## 1ausea2019002 - EXECUTIVE SUMMARY

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### Introduction and scope
- Technical note updating the Australian insurance sector and selected regulatory/supervisory aspects as part of the 2018 Financial Sector Assessment Program (FSAP).
- Prepared by Nobuyasu Sugimoto (IMF); drawing on discussions in Australia from June 6 to June 26, 2018.
- References Insurance Core Principles (ICPs) issued by IAIS in October 2011, revised November 2017.
- Focus on 10 selected ICPs: 2, 9, 10, 14, 15, 16, 17, 19, 23, 24.
- Does not provide a detailed ICP observance grading; the 2012 assessment was a full detailed ICP assessment.

### Market structure, products, and industry performance
- Size and concentration:
  - Insurers’ assets represented about 7 percent of total financial system assets as at the end of 2017.
  - Life 5.1 percent, health 0.2 percent, and general 2.1 percent of total financial system assets.
  - The top five life insurers accounted for more than 80 percent of total life industry assets as at the end of 2017.
  - Superannuation funds’ assets account for more than 20 percent of total financial system assets; largest share of business (4.3 percent) provided through superannuation trustees with group insurance.
- Growth and penetration:
  - Insurance penetration ratios for both life and general insurance were less than 3 percent in 2017.
  - Life insurance premiums have decreased about 1 percent since 2013.
  - General insurance premiums have grown only 2-3 percent annually since 2013.
- Industry composition:
  - Concentrated and focused on life/wealth management products related to superannuation.
  - High share of investment linked and protection type products in the Australian life insurance market.
  - Insurers can adjust premiums annually for long term protection products.
- Asset-liability and solvency:
  - Duration of assets and liabilities broadly matched; some entities use derivatives for hedging.
  - Industry average solvency ratios:
    - Life insurers: 200 percent as of end-2017.
    - General insurers: 182 percent as of end-2017.
    - Recent figures as of March 2018 declined for both life and general insurers to about 190 percent.
  - Regulatory minimum ratio: 100 percent for both life and general insurers.
  - Prudential capital requirement standard at the entity level is set relatively conservatively.
- Structural change:
  - Many large Australian life insurers sold by domestic conglomerates and purchased by foreign insurance groups (examples cited: OnePath, Colonial Mutual Life, MLC).

### Institutional setting and regulatory reforms
- Key authorities:
  - APRA: prudential regulation of ADIs, life, general and private health insurers and most of superannuation.
  - ASIC: market conduct regulation and consumer protection across financial services (excluding private health insurers).
  - RBA: monetary policy and payments/financial system oversight.
  - Council of Financial Regulators (CFR): coordination forum including Treasury.
- Recent reforms:
  - APRA implemented comprehensive prudential reforms, improved life-general consistency, group/conglomerate regulation and supervision (excluding level 2 group capital requirements for life groups).
  - ASIC shifted from government funding to industry funding and conducted thematic reviews (life insurance advice, claim handling, add-on car insurance, conflicts of interest).
  - New capital requirements: LAGIC implemented since 2013.
  - Level 3 conglomerate framework established relating to governance and risk management.
- Resourcing and governance:
  - APRA funded primarily by levies; 2017–18 Federal Budget provided an additional A$40 million over four years (total expenses in 2016–17 were A$129 million); headcount to increase by around 20 to some 640 staff in 2018–2019.
  - APRA and ASIC are subject to powers of government direction; both face budgetary constraints and recruitment/retention challenges (APS Workplace Bargaining Policy, APSC vetting, “efficiency dividend”).

### Main findings and emerging risks
- Prudential stance and supervisory capacity:
  - APRA’s prudential regulation and supervision reasonably conservative; risk-based capital framework reasonably conservative; APRA has high technical capacity.
- Emerging and increasing risks:
  - Recent increase in risk taking by some large, complex life insurers warrants enhanced regulation, supervision, and deeper cooperation with foreign supervisors.
  - Identified risk-increasing practices:
    - Creation of potentially risky offshore vehicles (captive reinsurance and investment vehicles).
    - Increase in holdings of foreign bonds due to shortage of domestic fixed income instruments to hedge duration exposure.
    - Offerings of new investment products using derivatives, securities lending, potentially with embedded leverage, risk concentration and disclosure issues not clearly regulated by APRA or ASIC.
    - Introduction and increasing sales of annuities with minimum investment guarantees and specified maturities.
  - Use of short-term hedging instruments (many hedges expire within a year) creates roll-over risk not incorporated into capital calculations.
- Group-level prudential gap and regulatory arbitrage:
  - Lack of group capital requirements for life insurance groups generates incentives to shift riskier activities and products outside regulated entities and offshore, potentially creating nascent systemic risks.
  - Recommendation for APRA to expand scrutiny of group activities, especially risky investments and material intra-group transactions.
- Conduct and reputational risks:
  - Royal Commission (established December 2017) exposed serious misconduct (e.g., charging for advice never received), eroding public trust; RC report due February 2019.
  - Discretionary Mutual Funds (DMFs) offer insurance-like “discretionary cover” but are not APRA-regulated; APRA ceased collecting DMF data in late 2016 and therefore lacks recent information on DMF size and activities.
  - Failure of DMFs to pay claims could create reputational risk for regulated sector.
- Independence, funding, and resourcing constraints:
  - Ministerial direction powers over APRA and ASIC may impinge independence; budget uncertainty hampers ability to attract and retain specialized staff.
  - Areas needing expanded resources: cyber, group, conduct, cross-border risks; enforcement; supervision of IT and operational risks; monitoring foreign activities and cooperation with international regulators.

### Solvency, valuation, and technical provisions
- Valuation standards:
  - Australian Accounting Standards require fair-value approach for valuation of assets and liabilities.
  - General insurers (GPS 320) must use a risk-free discount rate based on observable government bond rates.
  - Life insurers (LPS 340) use a risk-free discount rate for profit reporting except where benefits are contractually linked to assets; solvency discount rates should include a liquidity adjustment.
  - If total termination value exceeds value derived from risk-free discount rate (with liquidity adjustment), the excess is deducted from capital resources; future profits and DAC recovery excluded from capital resources.
- Liability assumptions and actuarial review:
  - Appointed Actuary requirements: annual review of assumptions for general insurers; professional judgment and available statistics for life insurers.
  - Valuation must allow for embedded options and guarantees; MOCE applies.
- MOCE and margins:
  - GPS 320 requires MOCE at minimum 75 percent level of sufficiency for general insurers; no APRA-specified methodology, IAAust guidance exists.
  - For life insurers, implicit composite margins eliminate day one profit; the conservatism adjustment difference reached A$11 billion industry-wide as of end 2017.
- Capital adequacy:
  - Capital adequacy framework targets a 99.5 percent confidence level over one year.
  - Minimum: PCA plus supervisory adjustment = PCR; breach requires immediate remedial action.
  - Capital resources in two tiers; Common Equity Tier 1 must exceed 60 percent of prescribed level; Tier 2 share is less than 5 percent on average.
  - Intangibles, goodwill and net deferred tax assets deducted from CET1.

### Asset oversight, unit trusts, and related-party exposures
- APRA does not routinely collect information on underlying assets of insurers’ unit trust investments and lacks ready access to underlying assets of outsourced investment activities.
- Life insurers’ total assets: A$230 billion at end-2017; majority related to unit trusts managed by group asset managers.
- Insurers may either look through unit trusts for capital calculation or treat investments as equity assets; leveraged and unlisted unit trusts require look-through.
- Related-party exposures (life insurers):
  - A$138 billion in 2015, A$144 billion in 2016, and A$70 billion in 2017.
  - APRA considers underlying assets of unit trusts not more risky than outsourcing or in-house management but applies capital charges where concentration limits exceeded.
- Investment concentration and ACRC:
  - ACRC provides incentives to diversify; exemptions and relaxed requirements exist for life insurers.
  - Limits: deposits with a single bank 50 percent of corresponding statutory fund; bills 25 percent; individual traded security limit 5 percent of corresponding statutory fund.
  - Life insurers’ investments in investment-linked products largely exempt from APRA prudential requirements (except where investment guarantees are provided).

### Stress testing, data, and supervisory analytics
- APRA conducts supervisory stress tests on a rolling three-year cycle; life insurers stress test in 2015 covered eight firms representing 70 percent of industry liabilities.
- Example stress scenario (life insurers, 2015):
  - 5 percent GDP fall;
  - house price decline by 43 percent;
  - equity prices drop by 44 percent;
  - credit spread increases by 2.7 percent.
  - Aggregate capital base dropped by 46 percent under the scenario but recovered after management actions.
- General insurers stress test (2016) scenario:
  - 3.8 percent GDP fall;
  - house price decline by 26 percent;
  - scenarios included earthquake or CTP claim liabilities over a three-year horizon.
- Observations on stress testing and data:
  - Validation challenges due to lack of granular, robust internal data; current IT reporting system in use for over 10 years and behind international best practice.
  - Regular reporting not granular enough to decompose management actions and risk mitigants.
  - Recommendation: enhance data and information collection at solo and group level and develop regular reporting tools to strengthen monitoring and reduce reliance on ad hoc surveys.

### Conduct supervision, disputes, and enforcement
- Disputes and claims handling:
  - General insurance disputes increased by 28 percent in 2017 vs 2016; life insurers’ disputes declined by 7 percent.
  - 33 percent of general insurer claims are related to Auto insurance; 69 percent of general insurers’ disputes concerned claim handling.
  - Income protection disputes heavily related to communication on ceasing benefits.
  - Most disputes resolved by mutual agreement; FOS decisions slightly more often favor financial providers than applicants.
- ASIC findings and reforms:
  - ASIC’s 2014 life insurance advice review found high lapse rates, failures to meet legal standards, material conflicts of interest; 37 percent of policyholders received advice that failed legal standard.
  - Remuneration reform: Corporations Amendment (Financial Advice Measures) Bill passed November 2015; cap on upfront commissions 60 percent of initial premium and 20 percent on ongoing premiums; claw back requirement for upfront commission if policy lapses in first two years; reform effective January 2018 but exemptions/grandfathering remain.
  - ASIC actions on add-on insurance: refunds totaling over A$120 million to over 210 thousand policyholders; proposals for deferred sales model; industry reducing commissions to car dealerships.
  - Consumer Credit Insurance (CCI): about 20 percent of consumers with mortgage, personal loans or credit cards also purchased CCI; overall denial rate 16 percent; one ADI had denial rate 47 percent for CCI sold with credit cards.
- Conduct supervision approach:
  - ASIC has shifted to risk-based supervision and increased insurance-specialist resources (Deposit Takers, Credit and Insurers team FTE rose from 28 to 83 from June 2012 to June 2017).
  - Supervisory activity remains heavily focused on remediation of materialized incidents; need for more forward-looking mitigation of misconduct risk.
  - Recommendations: strengthen ASIC enforcement powers (including product intervention powers), expand use of existing powers (including license suspension orders), and strengthen APRA‑ASIC coordination (expand ERM to capture conduct risks; pursue joint rule making, reporting and onsite inspections).
- ASIC initiatives on fintech:
  - Innovation Hub assisted about 300 fintech startups; regulatory sandbox caps include maximum 100 retail clients, total client exposure up to A$5 million, investments up to A$10,000 per retail client, general insurance coverage up to A$50,000 per policyholder (life insurers not allowed to use sandbox).
  - Proposed enhanced sandbox expands testing period to 24 months and scope; draft would allow life risk products up to A$300,000 coverage per retail policyholder and superannuation products up to A$40,000 investment per retail client.
  - ASIC exploring AI/ML for conduct supervision (natural language processing pilots).

### Key recommendations (highlights)
- Enhance independence and funding:
  - Eliminate ministerial direction powers and enhance funding/flexibility to retain experts (Treasury, APRA, ASIC) — Timing: ST — Priority: H.
  - Remove the possibility of the Minister giving ASIC a written direction; require disclosure in case of dismissal of APRA members/ASIC commissioners.
- Group capital and intra-group scrutiny:
  - Impose group level capital requirements on large and complex life insurance groups if high risk, capital creation, or capital relief transactions are identified (APRA) — Timing: ST — Priority: H.
  - Expand and deepen scrutiny of group activities, especially risky investments and material intra-group transactions (APRA).
- Data, stress testing, and supervision:
  - Improve supervisory data systems to facilitate risk analysis of complex insurer activities (APRA and ASIC) — Timing: C.
  - Continue to improve methods and data for robust validation of stress testing (APRA) — Timing: MT — Priority: M.
  - Enhance APRA data collection on underlying assets of unit trusts and outsourced investments.
- Conduct and enforcement:
  - Enhance coordination between APRA and ASIC to analyze and mitigate misconduct and prudential risks from wholesale unit trusts used by life insurers (APRA and ASIC) — Timing: MT — Priority: M.
  - Expand ERM to cover conduct risks and pursue joint work (joint rule making, reporting, inspections) (APRA and ASIC) — Timing: MT — Priority: M.
  - Strengthen ASIC’s enforcement powers and expand use of existing powers (Government and ASIC) — Timing: MT — Priority: H.
- Derivative hedging safeguards:
  - Provide additional safeguards for recognition of derivative hedging linked to adequate counterparty risk charges and liquidity management; monitor roll-over risk from short-term hedges (APRA) — Timing: ST — Priority: M.
- International cooperation and monitoring:
  - Further strengthen coordination with foreign supervisors of large insurers (ASIC and APRA) — Timing: I — Priority: M.
  - Resume periodic monitoring of Discretionary Mutual Funds (DMFs) (APRA and Treasury) — Timing: ST — Priority: L.

*EXECUTIVE SUMMARY, AUSTRALIA, INTERNATIONAL MONETARY FUND*

### EXECUTIVE SUMMARY ___________________________________________________________________________ 5

### 1ausea2019002 - EXECUTIVE SUMMARY ___________________________________________________________________________ 5

### Introduction and scope
- This technical note provides an update on the Australian insurance sector and an analysis of certain key aspects of the regulatory and supervisory regime as part of the 2018 Financial Sector Assessment Program (FSAP).
- Preparation and timeframe:
  - Prepared by Nobuyasu Sugimoto (IMF).
  - Drawing on discussions in Australia from June 6 to June 26, 2018.
- Reference standards:
  - References the Insurance Core Principles (ICPs) issued by the International Association of Insurance Supervisors (IAIS) in October 2011, as revised in November 2017.
- Focus and limits:
  - Analyzes practice in relation to selected ICPs with macrofinancial relevance and where material regulatory changes occurred.
  - Does not provide a detailed ICP observance grading; the 2012 assessment was a full detailed ICP assessment.
  - 10 selected ICPs used as focus: 2, 9, 10, 14, 15, 16, 17, 19, 23, 24.

### Market structure, products, and industry performance
- Relative size and concentration:
  - Assets held by insurers represented only about 7 percent of total financial system assets as at the end of 2017.
  - The top five insurers accounted for more than 80 percent of total life industry assets as at the end of 2017.
  - Superannuation funds’ assets are large and account for more than 20 percent of the total financial system assets.
- Industry composition and features:
  - Industry is concentrated and focused on life/wealth management products, related to superannuation products.
  - High share of investment linked and protection type products in the Australian life insurance market.
  - Insurers can adjust the premium annually for long term protection products, providing additional loss absorption flexibility.
- Asset-liability and solvency characteristics:
  - Duration of assets and liabilities are broadly matched; some entities use derivatives for hedging.
  - Industry average solvency ratio (at the entity level) is high and appears relatively resilient even under a risk sensitive solvency standard.
- Structural change since 2012:
  - Many large Australian life insurers have been sold by domestic conglomerate groups and purchased by foreign insurance groups.

### Institutional setting and regulatory reforms
- Key authorities and reforms:
  - Australian Prudential Regulation Authority (APRA) has undertaken comprehensive reform of prudential regulation, improved consistency between life and general insurers, and implemented group and conglomerate regulation and supervision (though not level 2 group capital requirements for life groups).
  - Australian Securities and Investments Commission (ASIC) shifted from a government funding model to an industry funding model.
  - ASIC has conducted important thematic reviews (life insurance advice, claim handling, vertically integrated institutions, conflicts of interest, add-on car insurance) and enhanced coordination with APRA.
- Ongoing reforms:
  - Projects to expand and improve data and information systems to underpin regulation and supervision.
  - New capital requirements (LAGIC) implemented since the 2012 FSAP.
  - A level 3 conglomerate framework established relating to governance and risk management.

### Main findings
- Prudential stance and supervisory capacity:
  - Prudential regulation and supervision by APRA is reasonably conservative.
  - The risk-based capital framework is reasonably conservative and facilitates supervisory risk assessments.
  - APRA has high technical capacity to conduct effective supervision.
- Emerging and increasing risks:
  - Recent increase in risk taking by some large, complex life insurers warrants enhancement of regulation, supervision, and further cooperation with foreign supervisors.
  - Identified risk-increasing practices include:
    - Creation of potentially risky offshore vehicles, such as captive reinsurance and investment vehicles.
    - Increase in holdings of foreign bonds due to shortage of domestic fixed income instruments to hedge duration exposure.
    - Offerings of new investment products, some using derivatives, securities lending, etc., without clear regulation (e.g., in relation to embedded leverage, risk concentration and disclosure) by either APRA or ASIC.
    - Introduction and increasing sales of annuities with minimum investment guarantees and specified maturities.
  - APRA cooperates with foreign supervisors (supervisory colleges) but there is scope to deepen supervisory cooperation.
- Group-level prudential gap and regulatory arbitrage risk:
  - Lack of group capital requirements for life insurance entities generates potential regulatory arbitrage incentives to shift riskier activities and products outside the regulated entity and offshore, which may lead to nascent systemic risks.
  - Recommendation for APRA to expand and deepen scrutiny of group activities, especially those entailing risky investments and material intragroup transactions.
- Independence, funding, and resourcing constraints:
  - APRA and ASIC are subject to powers of government direction that may impact their independence.
  - Both agencies face constraints and uncertainty in their budgets (particularly over the medium term), which may hamper attraction and retention of specialized staff.
  - Areas needing expanded resources: cyber, group, conduct, cross-border risks; enforcement; supervision of IT and operational risks; monitoring of foreign activities and cooperation with international regulators.
- Market conduct and enforcement:
  - ASIC has shifted to risk-based supervision from a compliance and event-driven approach and increased resources devoted to insurance supervision since the last FSAP.
  - Supervisory activity remains heavily focused on remediation of materialized incidents; need for more forward-looking mitigation of misconduct risk.
  - ASIC encouraged to strengthen enforcement powers (including product intervention powers) and expand use of existing powers (including license suspension orders).
  - Further strengthening of APRA‑ASIC coordination recommended to raise effectiveness of supervision of governance and conduct issues (expand ERM to capture conduct risks and pursue joint work such as joint rule making, reporting, and onsite inspections).

### Key recommendations (Table 1 highlights)
- Take steps to further enhance the independence of APRA and ASIC, including: (i) elimination of the direction that Minister can impose, and (ii) enhancement of funding and flexibility to retain and attract experts with specialized skills. (Treasury, APRA, and ASIC) — Timing: ST — Priority: H
- Impose group level capital requirements on large and complex life insurance groups if high risk, capital creation, or capital relief transactions are identified in the intra-group transactions. (APRA) — Timing: ST — Priority: H
- Improve supervisory data systems further to facilitate supervisory risk analysis of increasing complex activities of the insurers. (APRA and ASIC) — Timing: C
- Continue to improve the methods and data availability for robust validation for stress testing. (APRA) — Timing: MT — Priority: M
- Enhance coordination between APRA and ASIC to analyze and mitigate misconduct risks (such as suitability, disclosure, conflict of interest) and prudential risks (such as concentration, leverage, liquidity) stemming from the wholesale unit trusts used by life insurers for their investment linked products. (APRA and ASIC) — Timing: MT — Priority: M
- Provide additional safeguards to the recognition of derivative hedging, linked to adequate counterparty risk charges and liquidity risk management. (APRA) — Timing: ST — Priority: M
- Expand enterprise risk management (ERM) requirement to cover conduct risks and enhance coordination ideally by joint work such as joint rule making, reporting, and inspections. (APRA and ASIC) — Timing: MT — Priority: M
- Strengthen ASIC’s enforcement powers and expand the use of existing enforcement powers to mitigate future misconduct. (Government and ASIC) — Timing: MT — Priority: H
- Further strengthen coordination with foreign supervisors (especially those that are home supervisors of large insurers) to enhance the governance and risk management of internationally active insurance groups. (ASIC and APRA) — Timing: I — Priority: M
- Resume periodical monitoring of the size and development of Discretionary Mutual Funds (DMFs). (APRA and Treasury) — Timing: ST — Priority: L

### Additional observations from prior FSAP and supervisory practice
- 2012 FSAP identified issues including ministerial direction powers over APRA and ASIC, reliance on non-core earmarked funding for ASIC, lack of disclosure for reasons for removal of APRA/ASIC members, gaps in regulatory guidance for intermediary training/competency, missing legal powers to supervise insurer claim practices and policy servicing, and a desktop- and self-reporting-heavy ASIC supervisory approach.
- Since 2012, reforms include: implementation of LAGIC, level 3 conglomerate framework, thematic ASIC reviews identifying inappropriate practices, remuneration reforms, enhanced data collection, legal amendments to improve ASIC enforcement powers, policyholder remediation, and introduction of caps to sales commission on some products.

*EXECUTIVE SUMMARY, AUSTRALIA, INTERNATIONAL MONETARY FUND*

### 8.   The insurance industry in Australia is relatively small and suffering from low growth

### 8.   The insurance industry in Australia is relatively small and suffering from low growth

### Size and growth
- Life and general insurance accounted for 7 percent of total financial system assets (life 5.1 percent, health 0.2 percent, and general 2.1 percent respectively).
- The largest share of business (4.3 percent) is provided through superannuation funds whose trustee has a group insurance contract and distributes it to the individual members.
- Insurance penetration ratios for both life and general insurance were less than 3 percent in 2017.
- Life insurance premiums have decreased about 1 percent since 2013.
- General insurance premiums have grown only 2-3 percent annually since 2013, which is slower than general economic growth.

### Market structure and ownership
- The five largest life insurers account for more than 80 percent of the market share in terms of total assets; the five largest general insurers account for more than 75 percent of the market share.
- Ownership shifts: three out of four largest domestic conglomerate groups have divested their life insurance subsidiaries to foreign insurance groups.
  - Examples cited: OnePath life (2nd largest life) from ANZ acquired by Zurich Financial Group; Colonial Mutual Life (4th largest life) from CBA acquired by AIA; MLC (6th largest life) from NAB acquired by Nippon Life (80 percent) with 20 percent retained by NAB.
- Potential implications of foreign acquisitions:
  - New challenges for authorities and local managements.
  - Positive aspects include improved diversification, capacity to make investments to upgrade capability, and access to specialized insurance and wealth management skills.

### Profitability and solvency
- Life insurance sector Return on Equity (ROE) ranged from 9 percent to 15 percent over the last five years, with a clear declining trend in recent years.
- General insurers’ ROE ranged from 9 percent to 19 percent over the same period and is more volatile but typically higher than life insurers.
- Industry average solvency coverage ratios:
  - Life insurers: 200 percent as of end-2017.
  - General insurers: 182 percent as of end-2017.
  - Recent figures as of March 2018 declined for both life and general insurers to about 190 percent.
- Regulatory minimum ratio is 100 percent for both life and general insurers.
- PRUDENTIAL CONTEXT: The prudential capital requirement standard at the entity level is set relatively conservatively, indicating the sector is relatively resilient against a plausible adverse scenario.

### Interest-rate environment and legacy products
- Most life insurers stopped offering long term insurance policies with guarantees in 1980–90.
- Some legacy policies with guarantees sold more than 20 years ago remain; one largest insurer has about 30 percent of its insurance liabilities from the legacy portfolio.
- Duration of assets and liabilities is broadly matched; some firms use derivatives (interest rate swaps) for hedging.
- Most saving products are investment-linked products without guarantees; protection (term) products can have premiums adjusted annually.

### Asset allocation, hedging, and risks
- At the industry-wide level, majority of investments are held in high-quality government and corporate bonds and bank deposits.
- No striking evidence of searching-for-yield behavior or clear trend of credit risk taking at the industry-wide level.
- Increasing signs at individual company level of:
  - Expanding shares of assets invested in illiquid and foreign instruments.
  - Reliance on short-term hedging instruments (typically IR/FX swaps and forward).
- Identified risks:
  - Roll-over risk from short-term hedges where insurers might have to pay a much higher cost in the future.
  - FX risk in case of AUD appreciation leading to FX loss on foreign assets.
- Drivers: shortage of domestic fixed income instruments with high yield and extended duration prompting some life insurers to expand into illiquid and foreign assets.

### Conduct, public trust, and discretionary mutual funds (DMFs)
- Social and public pressure on financial institutions after revelations of misconduct led to the establishment of a Royal Commission (RC) in December 2017 to review misconduct in the Australian financial sector.
  - The RC hearings revealed serious misconduct issues, including admission by the largest life insurance group of misleading ASIC about charging customers for advice they never received.
  - Public and social trust in large financial institutions has been eroded.
  - High degree of media, public, and political attention likely to continue until the RC reports in February 2019 and the government announces its response.
- Discretionary Mutual Funds (DMFs):
  - Offer insurance-like “discretionary cover,” but are not subject to APRA prudential regulation.
  - DMFs do not have a legal obligation to pay claims and do not meet the insurance definition under the Insurance Act and Life Insurance Act.
  - DMFs appear to offer a wide range of insurance-like products, including liability “insurance” and car “insurance” to taxi drivers.
  - APRA used to collect information from DMFs under the Financial Sector Collection Data Act (FSCODA) but ceased collection in late 2016.
  - As of the cessation, APRA does not have recent information about the size, types of products offered, and activities of DMFs; the current size and product features of DMFs are unclear.
  - Recommendation: APRA is recommended to conduct periodical monitoring of the size and development of DMFs.
  - Reputational risk: Failure of DMFs to pay claims could create reputational risk for the regulated sector because society may not distinguish between insurers and DMFs.

### Institutional setting, supervisory responsibilities, and resources
- Functional regulatory structure:
  - APRA: prudential regulation of ADIs, life, general and private health insurers (including reinsurers) and most of the superannuation industry.
  - ASIC: market conduct regulation and supervision, promoting market integrity and consumer protection across the financial services sector (excluding private health insurers).
  - RBA: monetary policy and oversight of financial system stability and the payments system.
- Council of Financial Regulators (CFR):
  - Coordination forum for the three regulatory agencies and the Commonwealth Treasury.
  - Non-statutory body chaired by the Governor of the RBA.
- APRA governance and powers:
  - APRA governed by an Executive Group headed by an executive chairperson. APRA Act requires appointment of between three and five APRA members; currently (as of June 2018) there are three members.
  - APRA members appointed by the Governor-General on the advice of the Minister with terms not exceeding five years and eligible for renewal without limit.
  - APRA is subject to a formal power of direction by the Minister; directions must be published in the Gazette within 21 days and cannot be made on a particular case.
  - Government issues a Statement of Expectations (SOEs); APRA responds with a Statement of Intent (SOI); both published on APRA’s website.
  - Most APRA decisions are subject to judicial review; certain decisions are subject to administrative review; crisis-resolution decisions generally only judicial review.
- APRA funding and resourcing:
  - APRA is funded primarily by levies on regulated institutions; rates determined by the Minister after industry consultation.
  - 2017–18 Federal Budget provided an additional A$40 million over four years (total expenses in 2016–17 were A$129 million) for new initiatives (stress testing, IT security, review of industry remuneration practices, etc.).
  - The new budget will allow APRA to increase headcount by around 20 to some 640 staff in 2018–2019.
  - APRA can submit a New Policy Proposal (NPP) for additional funding and has received Special Appropriations in the past.
- Resourcing challenges:
  - APRA can hire risk specialists and industry experts, but recruitment and retention face constraints from APS Workplace Bargaining Policy, vetting by the Australian Public Service Commission (APSC), and an “efficiency dividend.”
  - These constraints create challenges to attract and retain highly specialized skills needed to oversee new technologies and evolving risks.
- Recent governance development:
  - Government announced appointment of a deputy secretary of the Treasury to become an additional deputy chairperson at APRA, subject to amendment of the APRA Act. Legislation introduced May 24, 2018, to create a second Deputy Chairperson; subject to Parliamentary agreement and Royal Assent.

*Source: IMF staff report — Chapter 8: "The insurance industry in Australia is relatively small and suffering from low growth" (extracted content).*

### 30.   ASIC is subject to a formal power of direction by the Minister under the ASIC Act. The

### 1ausea2019002 - 30.   ASIC is subject to a formal power of direction by the Minister under the ASIC Act. The

### Ministerial direction and governance of ASIC
- The Minister may give ASIC a written direction about the policies it should pursue, or priorities it should follow, in performing or exercising any of its functions or powers.
- The direction must be published in the Gazette within 21 days after the direction is given.
- ASIC must comply with a Ministerial direction.
- The direction cannot be made on a particular case, but the Minister can direct ASIC to investigate a particular matter when the Minister considers it in the public interest; the Minister cannot direct a particular outcome from the investigation.
- The government periodically issues Statements of Expectations (SOEs) to ASIC that elaborate on the Government’s expectations; ASIC responds with a Statement of Intent (SOI). Both SOE and SOI are published on ASIC’s website.
- Decisions by ASIC to issue legislative instruments, such as class orders, are subject to parliamentary review; either House of the Australian Parliament may disallow such an instrument (no disallowances have occurred in the past).

### ASIC capability review and enhancements (Box 1)
- A July 2015 Capability review (expert Panel) assessed ASIC capabilities as part of the Government’s response to the Financial System Inquiry (FSI).
- Panel findings:
  - Many of ASIC’s regulatory capabilities are in line with global best practices.
  - Areas for improvement: strategy, governance, IT, data infrastructure, information systems, and engagement with stakeholders.
- Government commitments and actions:
  - Committed A$61 million to enhance ASIC’s data analytics and surveillance capabilities and to modernize ASIC’s data management systems.
  - Additional powers proposed: a product intervention power; product design and distribution obligations for financial products.
  - Strengthening ASIC’s enforcement regime, including penalties; consultation on Treasury Laws Amendment Bill 2017 (in the parliamentary process at time of report).
  - Introduced an industry funding model for ASIC in July 2017, to ensure regulation costs are borne by entities that created the need for regulation.

### Review, accountability, and oversight mechanisms
- Many regulatory decisions of ASIC are subject to review by the Administrative Appeals Tribunal (AAT), allowing merits review.
- Some decisions are not reviewable on merits (e.g., where rights are otherwise protected).
- Legal challenges to ASIC decisions may be brought in the Federal, Supreme, and High Court.
- ASIC’s actions are subject to review by the Commonwealth Ombudsman; the Ombudsman may make recommendations but cannot change ASIC’s decisions (unlike the AAT).

### Funding, resourcing, and human resources
- ASIC shifted to an industry funding model in July 2017 following FSI recommendation.
- In 2017–18, approximately 65 percent of ASIC’s total budget will be funded by industry levies.
- ASIC increased resources into insurance work via specialist insurance practitioners.
- FTE change: Deposit Takers, Credit and Insurers team increased from 28 to 83 from June 2012 to June 2017.
- The Government continues to determine ASIC’s actual budget on a yearly cycle with a four-yearly forward estimate.
- ASIC can allocate general resources at its discretion; restrictions apply to resources funded by special arrangement. The Commission approves budgets and business plans for each team.
- Remuneration and employment flexibility:
  - ASIC employees remunerated according to the Australia Public Service pay classification.
  - Treasury Laws Amendment (Enhancing ASIC’s Capabilities) Bill 2018 was introduced in March 2018 to allow ASIC to employ staff more flexibly; APS Workplace Bargaining Policy and vetting by the Australian Public Service Commission (APSC) still impose constraints.
  - ASIC is subject to an “efficiency dividend” requiring a certain percentage of annual reduction in baseline budgetary resource as part of Australian Government policy.
- Staff turnover and training:
  - As of February 2018, staff annual turnover ratio increased to around 9 percent among overall staff, but higher among staff with long experience.
  - Staff turnover ratio is higher than that of APRA, particularly among those with long experience.
  - Training budget reduced since 2010–11 (though efficiencies may have improved).
  - Heightened public awareness of misconduct increases pressure to hire market conduct experts (lawyers, supervisors), posing additional recruitment and retention challenges.
- Leadership augmentation:
  - Government introduced legislation in March 2018 to create a second Deputy Chairperson position at ASIC, increasing Commissioners to five.
  - The new Deputy Chairperson took up office on 16 July 2018 and has experience in enforcement.

### Recommendations regarding independence and resourcing (paragraphs 36–37)
- Strengthen independence of APRA and ASIC to undertake their duties; remove Ministerial ability to give directions to APRA and ASIC on matters of supervisory policy and priorities.
- Support independent decision making by APRA members and ASIC commissioners with a requirement for disclosure in case of dismissal of an APRA member or ASIC Commissioner.
- Remove the possibility of the Minister giving ASIC a written direction.
- Equip APRA and ASIC with sufficient budget and flexibility to ensure adequate supervisory resources:
  - Need additional flexibility and predictability of funding to support recruitment and retention of staff with specialized expertise (IT, cybersecurity, advanced risk modeling).
  - Enact Treasury Laws Amendment (Enhancing ASIC’s Capabilities) Bill 2018 as early as possible to provide more flexibility of remuneration for ASIC staff.
  - Further upgrade APRA and ASIC information systems (data and IT systems) to support risk-based supervision and enforcement, especially for insurers’ conduct of business and complex activities (such as derivative transactions).

### Solvency requirements — Valuation of assets and liabilities
- Accounting standards require insurers to adopt a fair-value approach to valuation of assets and liabilities under the Australian Accounting Standards.
- Objective of fair value: estimate the price for an orderly transaction between market participants at the measurement date under current market conditions.
- For assets backing insurance liabilities, fair value methodology must reflect market assessment of value and risk. For other assets (small share of total assets), amortized cost is not prohibited.
- Liabilities valuation:
  - Generally via discounted cash flow with a risk-free discount rate and other assumptions.
  - Under GPS 320, general insurers must use a risk-free discount rate based on current observable, objective rates for government bonds.
  - For life insurers, for profit reporting under LPS 340, the discount rate must be a risk-free discount rate (except where benefits are contractually linked to assets backing the benefit, then a discount rate reflecting expected investment earnings on the assets is used).
  - For solvency purposes, discount rate should be adjusted to be the sum of the risk-free rate plus a liquidity adjustment even for policies where contractually linked rates apply.
  - If total termination value exceeds value derived from risk-free discount rate (with, where relevant, liquidity adjustment), the excess is deducted from capital resources; future profits and recovery from Deferred Acquisition Cost (DAC) would be excluded from capital resources.

### Liability assumptions and actuarial review
- Current estimates mainly based on insurers’ own experience with actuarial review.
- General insurers: Appointed Actuary must review assumptions for best estimate of insurance liabilities at least annually and disclose changes from previous period.
- Assumptions must be appropriate to insurer experience and class of business.
- Life insurers: Appointed Actuary must make best estimate assumptions using professional judgment with regard to available statistics; most life insurers large enough to assess their own lapse and expense experience.
- Mortality assumptions based on insurer’s own experience, informed by industry studies.
- Life insurers must separate acquisition expenses from non-acquisition expenses (acquisition expenses may be deferred and expensed over policy life).
- Valuation of technical provisions must allow for embedded options and guarantees; for life insurance these may be valued by suitable option pricing methods or via adjusted best estimate assumptions.

### Technical provisions and MOCE
- Technical provisions include Margin Over the Current Estimate (MOCE) explicitly in general insurance and implicitly in life insurance.
- GPS 320 requires MOCE at a minimum 75 percent level of sufficiency for general insurers.
- No APRA-specified methodology; Institute of Actuaries of Australia (IAAust) issued guidance as best practice for calibration.
- MOCE applied primarily to net insurance liabilities and must be determined according to uncertainty in gross insurance liabilities, reinsurance recoveries, and non-reinsurance recoveries; determined for each class of business with proper adjustment for diversification benefits.
- For life insurers, policy liabilities include composite margins that effectively eliminate day one profit; an adjustment for conservatism deducts the difference between best estimate liability and total termination values for all policies, acting as an implicit MOCE.
  - As of the end 2017, the difference reached A$11 billion at the industry wide level.

### Investment requirements and risk management
- Insurers must address investment risk in the Risk Management Strategy (RMS).
- Solo level and group requirements:
  - General insurance groups must address investment risk at insurance group level; Level 3 groups must address at conglomerate level.
  - RMS should establish Board approved investment risk and return objectives and cover security, liquidity, diversification, concentration, currency risks, and asset liability management.
  - Board Risk Committee must have full oversight of investment activities; similar group-level requirements apply for general insurers but not for life insurers.

### Asset Concentration Risk Charge (ACRC) and limits
- ACRC provides incentives to diversify investments, with exemptions and relaxed requirements for life insurers.
- Life insurers, general insurers, and general insurance groups must hold 100 percent of capital charge against a counterparty exposure that exceeds prescribed thresholds (this includes exposures to related parties).
- Exceptions exist (e.g., general insurers do not have a limit against reinsurers with high credit ratings).
- Life insurer limits on deposits held with and bills issued by a single bank (including parent or related bank) are:
  - 50 percent of the corresponding statutory fund for deposits.
  - 25 percent of the corresponding statutory fund for bills.
- Limit to an individual traded security is set at 5 percent of the corresponding statutory fund.
- Capital charge is exempted for assets linked to investment products without guarantee (capital relief applies only for policies where the policyholder bears the investment risk—i.e., investment linked policies—when there has been full disclosure to policyholders of the risks).

### Additional policyholder protections and prudential controls
- Insurance Act (IA) requires a general insurer to maintain assets in Australia equal to or exceeding total liabilities in Australia; capital held must exceed prudential capital requirement.
- For a branch insurer, assets in Australia must exceed liabilities in Australia by at least the amount of its minimum capital requirement.
- Life Insurance Act (LIA) requires life insurers to establish statutory funds relating solely to life insurance business or parts thereof; LIA prohibits mortgage or charging of statutory fund assets, controls movement of assets in and out of statutory funds, defines restricted investments (related-party dealings), and requires reporting of such restricted investments.

### Disincentives for complex or illiquid investments
- Risk-based capital regime and appointed actuary assessment help disincentivize complex investments.
- General insurers must apply to APRA before entering investments through SPVs or related entities where they wish to look through to underlying assets for large exposures and capital calculation.
- Life insurers face disincentives via capital calculation (e.g., treating complex assets as equity assets for asset risk charge calculations).
- Lower ACRC limits apply for less-liquid assets such as certain non-traded securities.

### Related-party exposures in life insurance
- High related-party balances mainly due to investments in unit trusts managed by a corporate trustee related to the life insurer.
- Life insurers’ material related party exposures: A$138 billion in 2015, A$144 billion in 2016, and A$70 billion in 2017.
- APRA considers underlying assets of these unit trusts not more risky than outsourcing to an investment manager or in-house management.
- Onsite reviews by APRA develop understanding of group structure, intra-group relationships, and insurers’ involvement with related parties.
- Balances exceeding concentration limits attract capital charges.
- Deductions from capital resources are made in respect of regulatory capital requirements of subsidiaries, joint ventures, and associates; intangible assets of these entities are deducted unless operationally independent, genuine arm’s length investments, not subject to prudential capital requirements, and not undertaking life insurance business or related business.
- Value of investments in subsidiaries, joint ventures and associates, less deductions, are subject to asset stresses in the Asset Risk Charge.

*International Monetary Fund — Australia (extract).*

### 47.   While APRA does not routinely collect information on the underlying assets of insurers’

### 1ausea2019002 - 47.   While APRA does not routinely collect information on the underlying assets of insurers’

### Asset oversight and unit trust investments
- APRA does not routinely collect information on the underlying assets of insurers’ unit trust investments and does not have ready access to information on the underlying assets of outsourced investment activities.
- Insurers can either (i) look through their unit trust investment and calculate capital requirements as if they directly hold the assets, or (ii) treat the investment as an equity asset; however, if the unit trust is leveraged and unlisted, insurers must look through and calculate capital requirements as if they hold the underlying assets directly.
- The total assets of the life insurers were A$230 billion in the end of 2017. According to APRA, the majority of the assets are related to Unit trusts managed by the group asset manager.
- Where insurers outsource investment activities, APRA assesses:
  - investment manager selection process;
  - process for manager reviews;
  - selection of appropriate benchmarks for assessing manager performance; and
  - circumstances under which continued investment through a manager will be reconsidered or terminated.
- APRA makes similar assessments for investments in unlisted assets through fund-of-funds structures, and reviews methodologies for selecting securities when investments are made directly.
- Assessments are supported by internal guidance material and a specialist market risk unit.
- APRA issues requirements to insurers or general insurance groups investing in assets where risks are not being adequately assessed or managed.

### Capital requirements (solvency framework)
- Capital adequacy requirements are in place at both entity and group levels (with the exception of life insurance groups), with a 99.5 percent confidence level over one year.
- Minimum requirement: Prescribed Capital Amount (PCA) plus any supervisory adjustment determined by APRA = Prescribed Capital Requirement (PCR).
- A regulated entity that breaches the PCR needs to take immediate actions to address the breach.
- Capital requirements cover a wide range of risks, including insurance, assets, concentration, and operational risks. Asset risks include interest rate, inflation, currency, equity, property, credit spread, and default.
- APRA aggregates risk charges using a specified correlation matrix to recognize diversification effects.
- Tax benefits can be recognized only up to the same amount of deferred tax liabilities with additional condition of legal enforceability.
- Life liabilities whose value depends on the illiquidity premium must be revalued using a stressed illiquidity premium:
  - stress adjustment: an increase of 30 basis points to the forward rates for the first 10 years after the reporting date and zero thereafter;
  - the stressed illiquidity premium is subject to a maximum of 150 basis points.
- Management actions permitted to reduce capital charges include reduction of termination values, discretionary benefits, adjustment of future premiums for existing policies, and change of asset allocations.
- Insurers use hedging instruments (interest rate, currencies and credit default swaps) to mitigate market risks; these provide capital relief under both standardized and internal model capital requirements.
- Capital requirements do not impose preconditions on hedging instruments (such as duration, credit quality of counterparties, and trigger events), creating incentives to use cheaper, shorter-duration instruments.
  - Sample checks indicated most hedging instruments relied on as of the end 2017 expire within a year, exposing insurers to roll over risk which is not incorporated into the capital calculation.
- Reliance on management actions (e.g., asset allocation changes) requires careful monitoring because such actions may not be feasible under stress or could induce market instability if many insurers act simultaneously.
- APRA has approved one general insurance group to use internal models for solvency setting.
  - APRA’s RDA Market Risk and Models team performs internal model validation across sectors.
  - APRA imposed rigid requirements including statistical quality test, calibrating test and use test, and a floor of 90 percent of the prescribed method for the first two years after approval.
  - Internal models must be independently reviewed at least once every three years.
  - The standardized approach is established on an economic capital basis, reducing incentives to adopt internal models industry-wide at this stage.

### Capital resources and group-level concerns
- Prudential standards classify capital resources into two tiers (Tier 1 and Tier 2, net of all specified deductions and amortization).
- Tier 1 comprises highest quality components (permanent, available, without servicing charge, subordination).
- Common Equity Tier 1 needs to exceed 60 percent of the prescribed level.
- The average share of Tier 2 in total available capital is less than 5 percent on average among life, general and reinsurers respectively.
- Intangible assets, good will and net deferred tax assets must be deducted from Common Equity Tier 1.
- Lack of a group capital requirement for life insurers may create undue pressure on life entities within large insurance groups or conglomerates:
  - capital instruments issued by a general insurer and held by the group life insurer can be eligible under prudential standards if held under investment link products, creating potential conflict of interest between group interests and policyholders.
  - Under severe stress, life insurers could be under group pressure to provide capital or liquidity to group entities (e.g., by investing in securitization products issued and arranged by the group bank).
- APRA monitors intra-group transactions, has imposed a group capital requirement on one life insurance group, and imposes arm’s-length requirements for related-party investments.

### Interlinkages and systemic risk (Box 2 highlights)
- Insurance sector’s contribution to systemic risk has increased since the global financial crisis; industry shifting to more asset-management type activities increases commonalities with other financial sectors.
- Australian insurance sector used to be highly connected with the banking sector via conglomerates and intra-group transactions; recent divestments have reduced intra-group transactions, but they remain high relative to other advanced jurisdictions.
- Life insurers have high investments into investment products managed in-house:
  - ASIC survey: investment linked products issued by life insurers on average invest 65 percent of the fund into in-house products.
- Investments under investment linked products are largely exempt from APRA prudential requirements and ASIC conduct requirements unless the insurer provides an investment guarantee.
  - Majority of investment is into unit trusts, mainly equity funds, structured as wholesale unit trusts potentially exempt from ASIC retail fund rules (investment, leverage, liquidity, concentration, use of derivatives).
  - Insurers must provide clear investment mandates and limits to protect policyholders of these products.
- APRA capital charges are exempted for such products (except operational risk) unless an investment guarantee is provided; thus, limited incentive for insurers to diversify these portfolios.
- Use of derivatives for leverage and security lending to enhance returns is observed; excessive concentration in group instruments or derivatives/securities lending with concentrated counterparties (typically the group bank) could result in contagion or increased step-in risk across the group.
- APRA and ASIC currently coordinate on conduct issues, but further joint analysis of interlinkages, conflicts of interest, and systemic risk implications of investment linked products is recommended.
- Potential regulatory measures include strengthening prudential and conduct regulation, enhanced disclosure, concentration/leverage limits for investments, and robust investment policies on instruments issued by group entities.

### Policy recommendations and supervisory actions
- APRA should impose group capital requirements on large and complex life insurance groups if high risk, capital creation, or capital relief transactions are identified in intra-group transactions; life insurers are subject to entity and statutory fund capital requirements, and a group-level requirement would provide an additional layer of policyholder protection.
- APRA should continue to monitor intra-group transactions and impose group capital requirements where warranted (APRA has already imposed a group capital requirement on one life insurance group).
- APRA and ASIC should strengthen coordination and monitoring of investments made through unit trusts linked to insurance products and consider applying regulatory requirements similar to those for retail unit trusts where necessary:
  - consider disclosure, leverage, concentration, liquidity requirements if monitoring reveals high concentration, leverage or liquidity risk.
- Additional safeguards for recognition of derivative hedging:
  - link hedging recognition to adequate counterparty risk charges and liquidity risk management;
  - monitor and impose restrictions in case of excessive reliance on short-term hedging instruments to address roll-over risk;
  - recognize counterparty credit risk for current exposure and potential future exposure;
  - monitor liquidity implications of large derivative positions (initial and variation margin requirements) and consider thematic reviews among large insurers on derivative use.

### Macroprudential regulation, surveillance and stress testing
- RDA division provides comprehensive support to frontline supervisors by monitoring macroeconomic environment, cross-sectoral developments, and systemic risk using data from regulated institutions and other sources; RDA produces internal tools and reports (quarterly industry outlooks, analytical tool kits, annual industry reports).
- Industry risk management framework includes industry risk registers and an industry risk report; the Supervision and Resolution Committee (SRC) oversees industry risk profiles and contributes to supervisory and resolution decisions.
- APRA conducts supervisory stress tests for both life and general insurers; RDA coordinates regular industry stress tests on a rolling three-year basis. Stress test results inform supervisory activities and challenge ICAAP management actions.
- Box 3: APRA Stress Tests (life insurers, 2015)
  - First supervisory stress test on life insurers in 2015 covered a large representative sample: eight firms (including two large reinsurers) participated; 70 percent of the industry by insurance liabilities was covered.
  - Foreign entities and activities were exempted.
  - Stress scenario details:
    - 5 percent GDP fall;
    - house price decline by 43 percent;
    - equity prices drop by 44 percent;
    - credit spread increases by 2.7 percent;
    - the scenario had a particularly severe impact on income protection insurance (both incidence and termination rates).
  - While the scenario severely impacted most participants, life insurers recovered after management actions; the aggregate capital base dropped by 46 percent.

*Source: 1ausea2019002 - 47. While APRA does not routinely collect information on the underlying assets of insurers’ (PDF chapter/section).*

### Box 3. APRA Stress Tests (concluded)

### Box 3. APRA Stress Tests (concluded)

### Stress test coverage and scenarios
- 2016 stress test on general insurers covered the four largest direct insurers and two largest reinsurers, which represent about 70 percent of the market in terms of gross premium.
- Participants covered all Australian entities within the group; foreign activities were exempted.
- The scenario assumed a 3.8 percent GDP fall and a house price decline by 26 percent.
- The two stress scenarios contained two different liability stresses (earthquake or Compulsory Third Party (CTP) claims) and a common economic stress; the liability stresses were not tailored to insurers and used the same underlying stress across firms.
- The scenarios assumed the stress took place over a three-year time horizon.
- Insurers assumed no adverse impact of the stress on reinsurance counterparty credit ratings/quality, on the view that the assumed scenario (such as the Australian earthquake event in isolation) would be unlikely to impact counterparties holding large and internationally diversified portfolios.

### Impact on insurers and variation by exposure
- The impact on an insurer varied depending on its exposure profile.
- In both scenarios, insurers suffered some losses in year 1; risk mitigation recovered most of the loss in year 2 and 3.
- After taking the benefits from management actions, the aggregate capital level returned to near pre-stress levels (life insurers’ exercise reported that capital positions could be recovered by taking various management actions).

### Management actions and common mitigants
- Most common mitigants reported:
  - dividend restrictions,
  - capital injections from the parent group,
  - premium rate increases,
  - adjustment of asset allocations,
  - capital raising from group entities or public.
- Some life insurers noted they could change premiums and policyholders’ dividends in an adverse scenario.
- Insurers assumed an increase of capital, albeit with re-pricing.
- Note: an increase of premium warrants careful consideration of how other competitors and policyholders behave.
- Mitigating actions reported by participants were consistent with those documented in their ICCAPs.

### Lenders’ Mortgage Insurers (LMIs) stress testing
- LMIs stress testing has been conducted twice as part of ADIs stress testing (in 2014 and 2017).
- Given similarity of risk and exposure between LMIs and ADIs, LMIs used the same macro-economic scenarios provided to ADIs, with a focus on a severe housing market downturn.

### APRA governance and future testing
- APRA is preparing for an upcoming stress test for life insurers planned to take place later in this year.
- Industry stress tests had been conducted on a three-year cycle: life insurers in 2015, general insurers in 2016 and ADIs in 2017.
- APRA has been increasingly centralizing stress testing resources and coordination through the dedicated Stress Testing Committee.
- Based on lessons from the three stress tests, APRA is improving approaches to make exercises more consistent while taking into account the heterogeneous nature of the insurance industry.

### Data, validation, and supervisory recommendations
- Stress test results have been validated with available data, but APRA staff faced challenges validating submitted results due to lack of robust internal data.
- The current IT system storing insurers’ data has been in use for over 10 years.
- The introduction of LAGIC in 2013 provided an opportunity to improve reporting, but APRA has not made a major upgrade of reporting requirements regarding the detail of capital requirement calculations and the supporting system; the system is clearly behind international best practice.
- Regular reporting requirements and data are not granular enough to decompose management actions and effects from risk mitigation instruments.
- There is not sufficient data to validate either gross or net exposures.
- Recommendation:
  - APRA should enhance their data and information collection further both at solo and group level to enable supervisors to deepen analysis of individual firms and sectoral risks.
  - APRA should develop regular reporting tools to strengthen monitoring and analysis of potential stress and reduce reliance on ad hoc surveys, drawing on lessons from stress testing exercises.

*Source: 1ausea2019002 - Box 3. APRA Stress Tests (concluded)*

### 76.   FOS reported that general insurance disputes increased by 28 percent, but those of life

### 76.   FOS reported that general insurance disputes increased by 28 percent, but those of life

### Disputes and outcomes
- General insurance disputes increased by 28 percent in 2017 compared with in 2016.
- Life insurers’ disputes declined by 7 percent in 2017 compared with in 2016.
- 33 percent of the claims of general insurers are related to Auto insurance.
- 69 percent of general insurers’ disputes concerned claim handling (such as denial of claim or the amount of payment).
- The most common disputes for life insurers is denial of claims.
- In income protection disputes, disputes are heavily related to communication from insurers to policyholders regarding the ceasing of benefits.
- Most disputes have been resolved by mutual agreements.
- Of disputes decided by FOS, slightly more are found in favor of the financial providers than the applicant policyholders.

### Causes and industry response
- Industry representatives attribute the increasing number of disputes mainly to increasing awareness of policyholders’ rights.
- Claim handling process improvements: increasing resources, strengthening process and governance in claim handling at most insurers, although there are mixed views on the current status of the improvement among industry representatives.
- Whenever FOS identifies systematic issues, FOS is required under its Constitution to inform ASIC and the two bodies will coordinate to address the problem.

### ASIC review of life insurance advice (2014) and findings
- ASIC found material problems: high lapse rates, failures to meet legal standards and material conflicts of interest.
- ASIC’s review comprised roundtables, a survey of twelve life insurers and targeted surveillance of advisers who provided advice on life insurance products.
- Findings included:
  - High lapse rate (more than 14 percent) for major life insurance policies with step up premium adjustments.
  - Significant variation on the quality of advice; 37 percent of the policyholders received advice that failed to meet the relevant legal standard.
  - Advice given on products with an upfront commission have a significantly higher fail rate.
- ASIC concluded that the impact of adviser conflicts of interest on the quality of life insurance advice is an industry-wide problem.

### Remuneration reform and ASIC supervision
- Corporations Amendment (Financial Advice Measures) Bill passed in November 2015 to introduce remuneration reform covering life insurance products.
- Reform effective from January 2018, although exemptions are granted to certain life insurance products such as existing policies.
- Key components:
  - Cap on upfront commissions equal to 60 percent of the initial premium and 20 percent on ongoing premiums.
  - Claw back requirement: portion of the upfront commission repaid to the insurer if the life insurance product lapses in the first two years.
- Grandfathered commissions:
  - Because of exemptions and permanent grandfathering arrangements, grandfathered commissions continue to form a significant portion of adviser remuneration.
  - Grandfathered commissions incentivize advisers to keep clients in legacy products, even where better alternatives may exist.
- ASIC actions:
  - Engaging with AFS licensees, advisers and professional associations.
  - Updating consumer information requirements and expanding data collection.
  - Committed to conduct a post-implementation review in 2021 to assess the impact of the reforms.

### Life insurance claim handling review
- ASIC examined claim handling practices for death, disability, trauma, and income protection.
- No evidence of cross-industry misconduct across life insurers, but issues of concern in declined claim rates and claims handling procedures associated with particular types of policies (disability), particular insurers, direct sales channels and particular causes of consumer disputes.
- Some claims declined on technical grounds not in accordance with the spirit or intent of the policy.
- Thematic follow-up reviews focused on higher decline rates; decline rates were higher for policies sold without personal advice and for disability insurance.
- Most claim-related disputes related to:
  - The evidence required from the policyholder to assess their claim.
  - The timeframes taken by an insurer to assess a claim.
- Identified limitations in current claim data, making comparisons across insurers difficult.
- ASIC and APRA are working on ongoing data collection and publication at the industry and insurer level.

### Add-on insurance sold through car dealerships
- Add-on products include tire and rim insurance, Consumer Credit Insurance (CCI) and GAP cover.
- ASIC identified systemic problems: significant low claim ratios due to restrictions in cover and overlapping cover, suggesting extremely poor value for policyholders.
- Sales environment: high-pressure; reverse competition where insurers pay extremely high commission (up to 80 percent) to gain access to car dealer distribution networks.
- Car dealers earned four times more in commission than consumers received in claims.
- Remedial actions:
  - Refunds totaling over A$120 million paid to over 210 thousand policyholders.
  - Industry reducing commissions to car dealerships.
  - ASIC issued a consultation paper proposing a deferred sales model requiring a pause in the sales process, introducing tools to improve consumer decision making, enhanced supervision obligations for insurers, and use of technology to improve the sales process.

### Consumer Credit Insurance (CCI) sold by ADIs
- CCI usually sold when applying for credit or after taking a credit product.
- ASIC complaints highlighted conduct issues: CCI sold without consent, pressure tactics, misleading representations, and serious deficiencies in sales scripts.
- A large proportion of CCI claims are denied.
- Statistics and findings:
  - About 20 percent of consumers with mortgage, personal loans or credit cards also purchased CCI.
  - The majority of consumers of personal loans also purchased CCIs.
  - Overall rate of denied claims was 16 percent; one ADI had a denial rate of 47 percent for CCI sold with credit cards.
  - 14 percent of CCIs were cancelled during the 1 year review period for reasons other than the closure of the loan.
- Script deficiencies across ADIs:
  - Seven ADIs had scripts that did not point out that purchase of CCI was optional.
  - Four ADIs used potentially ambiguous words (activate, enroll, process) to confirm purchase.
  - Nine ADIs had scripts without a clear question about consumer consent.
  - Ten ADIs had scripts that did not point out the main applicable exclusion.
- ASIC actions:
  - One ADI refunded over AUD 10 million to policyholders.
  - A working group developed a deferred sales model and better sales practices incorporated into the Banking Code of Practice.
  - New deferred sales model: offer CCI after issuance of a credit card; includes enhanced disclosure and customer consent processes.

### Conflict of interest from group entities and group supervision
- Vertical integration persists in several large financial entities covering banking, insurance, superannuation, asset management, and financial advice services.
- Potential risks of inappropriate advice due to conflicts of interest from vertically integrated business models, despite adviser duty to act in the best interest of policyholders.
- ASIC review of largest banks and financial services institutions:
  - All financial institutions provide both in-house and external products; investments skewed to in-house products.
  - In insurance, share of in-house products was 65 percent.
  - Most advice reviewed did not comply with regulatory requirements; unnecessary replacement of financial products common, especially related to insurance products in superannuation.
  - In 10 percent of files reviewed, ASIC found significant concerns about the potential impact of noncompliant advice on the customer’s financial situation.
- ASIC regulatory actions include enhanced monitoring, enforcement actions (revocation of licenses and criminal prosecution), and a project focused on remediation where advice-related failures led to poor customer outcomes.

### Recommendations
- ASIC should continue to build supervisory effectiveness on insurance conduct issues by:
  - Taking a more forward-looking approach.
  - Strengthening cooperation with APRA.
- Observations and suggested actions:
  - ASIC has transitioned to risk-based supervision and improved conduct supervision effectiveness, but activities still focus heavily on remediation of materialized incidents; greater emphasis needed on preventative actions to mitigate future misconduct risks.
  - ASIC could enhance cooperation with APRA to expand the ERM framework to cover conduct risks.
  - Future conduct risk mitigation through robust governance and risk management in key processes: product design, level and design of commissions, marketing and advertisement tools, training of sales channels.
  - ASIC and APRA should coordinate closely, ideally through joint reporting requirements and inspections to follow up ERM requirement implementation.
- Strengthen ASIC powers:
  - Authorities should continue efforts to strengthen ASIC powers for intervention, correction, and enforcement.
  - Current limitations noted: lack of power to intervene to ban or prohibit conduct in relation to products and require changes to align product design with customer needs (legislation to provide these powers is in draft form).
  - Maximum civil penalties ASIC can apply are low and often less than benefits obtained from contravening conduct.
  - A civil penalty cannot currently be imposed for failure to report material misconduct incidents.
  - Government agreed or agreed-in-principle to ASIC enforcement review taskforce recommendations; implementation pending and may overlap with RC recommendations.
  - Early and clear government commitment to enhance ASIC powers would strengthen remediation negotiating power and improve internal governance of insurers.
  - Product intervention powers would help encourage standardization, simplification, improved sales materials and practices, and quality of advice.
- Use of existing enforcement powers:
  - ASIC should make best use of existing enforcement powers (including suspension and revocation of licenses) to generate stronger incentives for insurers to improve conduct risk management.
  - More active use of strong powers, accompanied by disclosure of actions, could improve social trust in the sector.

### Box 5. ASIC Initiatives on Fintech
- ASIC promotes innovation through initiatives: Innovation Hub, Regulatory Sandbox and the Enhanced Sandbox proposal, balancing innovation and consumer protection.
- Government and ASIC actions: establishment of a FinTech Advisory Group, Backing Australian Fintech statement, and a new bill to expand the ASIC Regulatory Sandbox.
- Innovation Hub:
  - Assisting about 300 fintech startups to navigate regulatory requirements.
  - Provides designated contacts, one-stop information, and coordinated internal engagement.
  - Includes a Digital Finance Advisory Committee of nine external experts.
- ASIC regulatory sandbox conditions (12-month licensing exemptions) include caps to mitigate consumer risk:
  - Maximum of 100 retail clients.
  - Total client exposure up to A$5 million.
  - Investments up to A$10,000 per retail client.
  - In general insurance up to A$50,000 coverage per policyholder (life insurers are not allowed to use the regulatory sandbox).
  - Core conduct disclosure requirements remain applicable.
- Observations on Insurtech:
  - ASIC observes limited Insurtech developments but notes collaboration between start-ups and incumbents, especially in general insurance (examples: micro-insurance on blockchain, improved claim handling, tailored marketing and pricing).
  - Near-term expectation: ASIC is not expecting major disruption in the insurance sector.
- Proposed enhanced sandbox (October 2017 draft regulations):
  - Testing period length up to 24 months and instances of entry expanded.
  - Expanded scope to allow additional services and products.
  - Proposal expands eligible services to life risk products up to A$300,000 coverage per retail policyholder and superannuation products up to A$40,000 investment per retail client.
- ASIC capacity and expected demand:
  - ASIC approves over 700 AFS license applications yearly and provided informal assistance to over 200 fintech businesses over the last two years.
  - ASIC suggests a material portion of these businesses could use the proposed enhanced sandbox, potentially in the hundreds per year, posing supervisory challenges.
- AI/ML applications:
  - ASIC exploring AI and ML to enhance conduct supervision; currently devoting significant staff resources to monitor sales calls and review advertising materials.
  - Initiated pilot models using natural language processing; pilot testing finds significant potential.
  - Given resource limitations and social expectations for policyholder protection, such projects should be prioritized and supported by appropriate budget allocation to confirm feasibility.

*International Monetary Fund — Australia chapter excerpt*

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_Source: https://www.imf.org/-/media/files/publications/cr/2019/1ausea2019002.pdf_