Hih Debacle Gives Strength To Arm Of The Regulator
The Age
Friday March 30, 2001
Coming only a fortnight after the collapse of HIH Insurance, yesterday's release by the Australian Prudential and Regulatory Authority of its proposed supervisory arrangements for general insurers may generate some cheap laughs.
While it is an unfortunate coincidence that APRA has produced its revised proposals so soon after one of the biggest general insurers in the country has failed in such a spectacular and messy fashion, however, the HIH experience will serve at least some useful purpose.
Before HIH, there was some resistance in the industry, and indeed even among some of the old insurance regulators, to APRA's new-fangled, banking-style approach to supervision. It was seen to be too costly, potentially restrictive and overly conservative for an industry built on risk-taking. It was also seen as too intrusive and as undermining the authority of insurers' boards and management.
Post-HIH, it would be a brave insurer that would be prepared to take on APRA and challenge its approach. There might still be some refinement of its proposals at the margin, but the broad thrust of its approach will be implemented.
APRA's resolve will have been strengthened by the embarrassment of the failure of HIH on its watch and that of its industry critics weakened.
APRA is too new for there to have be any charge that it has moved too slowly in introducing a modern framework for regulating an industry that is still regulated on the basis of 28-year-old legislation.
It is instructive, however, to consider what might have been, had the new requirements been in place some time ago.
There are a number of elements to the new framework proposed for supervision. Some are what might be loosely described as arithmetic, some structural and some atmospheric.
At the heart of the proposals are a standardised approach to valuing liabilities and a capital adequacy regime tailored for insurers.
Estimating liabilities is as much actuarial art as science - it is an assessment of the probabilities of claims and losses from a portfolio.
APRA's objective is to produce consistency in the approach to estimating liabilities across the industry and, in the absence of a deep market for risk, is based on an arbitrary proxy for a market price, which APRA has set at the 75th percentile of possible outcomes.
Insurers will be able to make their own assessments of liabilities but will have to publish the number thrown out by the APRA formula in their accounts and explain why they have chosen to depart from it.
That will introduce significant discipline into the valuation and reporting process, and make it more transparent and easier for shareholders, analysts and regulators to make comparisons.
The capital adequacy regime will lift the required minimum capital levels for the industry by, on average, 40 per cent to 50 per cent by comparison with the existing regime. APRA says that while the proposals would lift regulatory minima, few companies in the industry would be expected to need new capital as a result.
The interaction between the liability valuation standard and the capital adequacy standard would be, in effect, to make valuations potentially more conservative and require greater capital support - there would be an increase in provisioning and capital and therefore a substantial improvement in the quality of balance sheets for the marginal players.
Given that a possible cause of HIH's difficulties may have been consistent underprovision for its claims experience - consistent underestimation of its liabilities - the new proposals would clearly have affected HIH and reduced the magnitude of its problems had they been in place some years ago.
HIH, unusually for the industry, didn't have a reserve or prudential margin to provide a buffer is case it underestimated its liabilities. That had the ``helpful" effect of making its results look better than they would have had it adopted normal practice.
It was known, well ahead of the collapse, that HIH would need to raise several hundred millions of dollars of new capital, even on the basis of its published accounts, to meet the APRA requirements.
The other elements of APRA's proposals are less technical but fundamental to the new framework. It assigns a much clearer responsibility for governance and compliance to insurers' board and management and plans to add a new player, a valuation actuary, to the mix.
The actuary, who would be in effect licensed by APRA, would be responsible for the calculation of the insurer's liabilities on the APRA basis. Both the actuary and the insurer's auditors would be required, under so-called whistleblower provisions, to report any breaches of prudential requirements or any risk to policy holders to APRA.
APRA has made it clear that it will still be the board and management's responsibility to determine the value of liabilities, with the actuary acting as an expert adviser. In practice, few insurers will be willing to take the risk of challenging the APRA method of calculating liabilities in their accounts unless their own method is demonstrably more conservative.
The proposed standards, it should be noted, are regulatory minima. Companies can, as some already do, use more conservative approaches and carry more than the minimum capital required. In the banking system, any bank that ran its capital adequacy levels down close to the regulatory minimum would trigger alarms and fierce scrutiny from the market.
The APRA proposals are quite broad and, by comparison with the banks' capital adequacy regime, quite crude. Over time, however, APRA and the industry will inevitably develop more sophisticated standards and processes for evaluating risks and the capital required to meet them.
The Basle regime for banks has driven extraordinary developments in the banks' ability to analyse, value and manage risk and the capital associated with it.
The general insurance sector, partly because of complacent and inadequate regulation in the past, hasn't had the same level of sophistication - although there are some sophisticated and sensibly managed companies within it. The bank regime has also driven far greater transparency in its accounting.
After the $3 billion wipe-out of the Australian reinsurance sector and now HIH, however, the industry has no option but to accept the APRA proposals. At the smaller end of the market in particular, that may increase costs and force the raising of new capital, but after the HIH experience they are either going to have to meet the new rules or quit the industry.
There is plenty of time for the industry to respond, with APRA hoping to introduce the new regime from next year but with a five-year phase-in. After the HIH debacle, no one would dare complain if that timetable were accelerated.
bartho@theage.fairfax.com.au
© 2001 The Age