Canberra Right To Fast-forward Tough Insurance Regime

The Age

Wednesday May 16, 2001

STEPHEN BARTHOLOMEUSZ

The Federal Government's decision to bring forward the introduction, and accelerate the implementation, of the Australian Prudential Regulation Authority's tough new regime for general insurers is undeniably the right thing for it to do in the wake of the HIH disaster.

Confidence has to be restored and, given the wake-up call provided by HIH's collapse, the government would have been reckless to leave the discredited, 28-year-old regime in place.

Industry opposition to the APRA regime, which had frustrated the progress of the proposals and softened APRA's requirements, has collapsed with HIH.

The new regime, which introduces a capital adequacy regime analogous to that under which the banking sector operates and lifts the minimum capital required from $2 million to $5million, was originally going to be phased in over five years, starting from the middle of next year. The phase-in period has been cut to two years. The nature of the new requirements, and that accelerated timetable, is going to put some pressure on the industry.

The core of the new regime is the new risk-adjusted capital adequacy framework, which introduces capital ``factors" designed to adjust capital requirements to the level of perceived risk in the types of business being written.

That is buttressed by a standardised, relatively conservative, approach to valuing liabilities, with the interaction between the capital adequacy requirements and the valuation of liabilities producing a leveraged improvement in the quality, consistency and transparency of insurers' balance sheets.

Add in the introduction of an APRA-licensed actuary, ``whistleblower" provisions for the actuary and the auditors, and clearer definition of the responsibilities of boards and management, and the long-overdue reforms to a neglected sector ought to produce a far more robust prudential regime.

Most of the industry, and certainly those larger general insurers still standing, ought to be able to meet the new requirements without too much difficulty.

When APRA road-tested its latest version of the requirements, it found that, for the 53 companies assessed, the solvency requirement rose from $3.3 billion to $4.9 billion. The companies, however, already had aggregate capital of $10.4billion. As a sector, the surviving general insurers have more than enough money to make the transition to the new regulatory environment.

Financial Services and Regulation Minister Joe Hockey said yesterday about 25 of the 153 general insurers operating in Australia would not meet the new requirements and did not have a parent to provide the capital required.

(The issue of potential parental support may explain why Mr Hockey's numbers differ from other estimates that up to a third of the industry's participants will need to raise capital to meet the new APRA rules.)

One suspects many, if not most of the 25 companies to which Mr Hockey referred, do not meet the new $5million minimum capital requirement. Clearly they will have to raise capital over the next two years or exit the industry.

The combination of the need to raise funds, the limited time frame within which to do so, the environment for capital-raising by general insurers post-HIH and the inevitable increase in compliance costs created by the new regime will cause some rationalisation of the sector. And the culling will not necessarily be confined to the smaller end of the market.

Arguably, given the HIH-demonstrated public interest in the solvency of general insurers, the minimum capital requirement should be higher, even if that lifts the barrier to entry to the industry and reduces to some degree the intensity of competition.

KPMG insurance partner Don Findlater has said his firm believes $10 million would be more appropriate.

But ultimately the capital adequacy regime and its ability to influence and restrict the level of risk an insurer exposes itself to by tying risk to the levels of capital required to be held against specific risk provides the more powerful protection against failure.

The other development in the industry that will make the transition, and the potential, if necessary, to raise capital, somewhat easier than it might have been is that profitability in the sector ought to rise sharply over the next couple of years.

HIH was a business built on, it now transpires, unsustainably low pricing. It was a price leader in the sector because, it appears, it consistently underpriced the risks to which it was exposing itself.

Deliberately or otherwise, it also appears to have consistently under-stated its liabilities, inflating its apparent profitability and reducing the level of capital required.

Now that it has disappeared, premiums are already rising sharply and will continue to do so.

Indeed, the new regime will, by focusing increased attention on returns on risk-adjusted capital, create greater precision in pricing and inevitably higher prices. Plus there will be the higher compliance costs of the new regime for the insurers to recover.

The insurers' products will be more expensive and their profitability enhanced. This is not necessarily a bad thing. As with banks, it is better to have a profitable and therefore stable industry, even if there is a trade-off in terms of consumer benefit, than an unprofitable and unstable one.

The rush to introduce the new regime might appear, and indeed is, a case of bolting the stable door after the horse has bolted. Under the old regime, it was not just HIH that disappeared in a $4 billion-plus implosion, but almost the entire local reinsurance sector. That adds a further $3 billion-plus to the tally.

That, perhaps, is not all that surprising when an industry operating in an increasingly dynamic, volatile and global environment was governed by 28-year-old legislation and, until APRA was created, a complacent and ineffective regulator. The test of APRA and its new rules will be whether it does any better in the long run.

bartho@theage.fairfax.com.au

© 2001 The Age

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