Insurers Lost In Bungle Land

The Age

Saturday September 16, 2000

STEPHEN BARTHOLOMEUSZ

HIH Insurance's forced sale of control of its Australian retail general insurance business this week was a reminder of what a horrible 18 months or so it has been for the general insurance sector.

The Australian Prudential and Regulation Authority's annual report, also issued this week, underscored just how bad it has been.

The report said the industry's reinsurance component alone had recorded about $3 billion aggregate losses in 1999-2000.

GIO (more than $1 billion losses), Reinsurance Australia (nearly $500 million) and New Cap Re (more than $200 million) were the biggest and most visible local casualties of the natural disasters and mismanagement that effectively wiped out most of the domestic reinsurance industry.

It seems from APRA's numbers there were others as well.

It appears the problems, while focused on reinsurance, were not confined to this sector, with APRA saying a third of the 155 authorised general insurers incurred operating losses and another third were only marginally profitable.

But what happened in the reinsurance segment is an indictment of its management and risk-assessment and control structures. Plenty has been said and written on that account.

Interestingly, insurance is a regulated sector with a prudential supervisor - the industry has operated under the Insurance Act for 27 years and, until APRA was created, had an industry-specific regulator/supervisor, the Insurance and Superannuation Commission.

But there has been very little focus on the breakdown in supervision that the losses suggest.

It would be difficult not to conclude that $3 billion losses within what APRA describes as a ``relatively small component of the local industry" represents regulatory failure, particularly as most of the losses were within a small group of relatively large companies - the companies one would normally assume were the most closely supervised.

The Reserve Bank was the target of criticism for the role it played, or did not, in the credit problems and balance sheet stress in the banking industry in the early 1990s, which destabilised the industry and damaged the economy.

The RBA subsequently quite radically changed its approach to supervision and the kinds of risk control and capital management processes and structures it encouraged.

APRA, which now includes responsibility for bank supervision, is too new to carry blame for the insurance strife - the year just ended was only APRA's second of existence and its first with full supervisory responsibilities - which probably means the fault lies with the old ISC.

Obviously, the ISC cannot be held responsible for the natural disasters that caused GIO to breach its solvency requirements, or that decimated ReAc and New Cap Re.

But the magnitude of the losses says that the understanding of risk and controls over the level of risk being incurred was inadequate at corporate and regulatory level.

In effect, the reinsurance meltdown vindicates the creation of APRA and APRA's emphasis on developing a new approach to supervising insurers.

APRA is developing and implementing what could be determined a bank-style approach to prudential regulation of insurers, with a focus of capital adequacy and risk-awareness and management systems.The new approach to supervision aims to supervise similar risks in a like manner, regardless of the type of institution.

That, driven by the emergence of increasingly diverse and complex financial conglomerates, as well as increasing opportunities for regulatory arbitrage, was a core element of the philosophy of the Wallis Committee recommendations which led to the formation of APRA.

It would appear APRA also wants to adopt the Reserve Bank approach to supervising banks for all its larger institutions. As indicated, before it lost its bank supervisory role to APRA, the RBA focused on the quality of management controls and systems for dealing with risk rather than the old audit-style approach to supervision.

For insurers, APRA has issued several discussion papers that originally caused some agitation and resistance within the industry, but which appear to be gaining support. APRA has issued draft standards on liability valuation, capital adequacy and operational risk and hopes to introduce new prudential standards by mid-2002.

Just as the banking sector has developed increasingly sophisticated systems and approaches to identifying risks and the appropriate levels of capital to support them in the wake of the industry's brush with disaster at the start of the 1990s, APRA is encouraging insurers to develop more sophisticated models to identify and measure risks.

It is also considering including an operational risk dimension to its new capital adequacy regime.

The APRA approach will not stop natural disasters but it might help, in future, to contain their impact on individual insurers. If it does not, of course, there will be no doubt about which regulator will share the blame.

The APRA annual report also contained another interesting discussion point, with the regulator showing some concern at the impact of the aggressive capital management programs that major banks have adopted to lift shareholder returns.

APRA says the capital ratio for the sector was 10 per cent at 30 June, comparable with its level since June 1998 and above the 8 per cent statutory minimum. But APRA notes that the ratio was about 12 per cent until 1995, when it started falling.

The regulator attributes the narrowing of the buffer over the minimum capital ratio requires to the banks' efforts to maintain returns on equity in the face of strengthening competition and a growing ability of institutions to measure more precisely their internal capital requirements.

That has resulted in far more active capital management through share buybacks and securitisation (which APRA says now amounts to about 7 per cent of the banks' collective balance sheets and which has made the Australian market for securitised assets one of the world's largest in relative terms).

APRA is clearly uncomfortable with the lower capital ratios and says it will explore the issue with the banks.

At face value, lower buffers over minimum capital requirements imply lower margins for error and therefore greater systemic risk, particularly at this point in a very strong and therefore, for the banks, benign economic cycle.

Complicating assessment of the degree of risk the lower levels of capital carried might imply, however, is the reality that since the mid-1990s all banks have radically changed their approach to provisioning for loan losses.

Westpac started the rush to what in termed ``dynamic provisioning" and everyone else has adopted their own version of counter-cyclical provisioning.

That could be seen as the 1990s version of the 1970s practice of creating ``hollow logs" that could be drawn on in tougher times.

In the 1970s, the hollow logs were vast property holdings recorded at cost within the bank balance sheets. Today the insurance against a sudden hike in bad debt probably lies in the provisions.

With the banks getting more sophisticated in their ability to identify and properly price risk and the amount of capital needed to support it, simple capital adequacy ratios adjusted with crude risk-weightings probably are not a precise guide to the system's underlying resilience.

That is why international banking regulators are spending considerable time and effort trying to introduce greater sophistication and precision into the capital adequacy regime.

bartho@theage.fairfax.com.au

© 2000 The Age

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