July 2010

Good news all around, for the most part, but new forms are due to APRA on 30 September – not far away!

On the 23rd of June APRA issued the final version of new reporting standards that aim to harmonise APRA prudential reporting with financial reporting prepared under Australian accounting standards. The new rules, which apply from 1 July 2010, will make reporting, understanding, and interpreting information for APRA and other users significantly easier. They will also remove a number of distorting features of the current prudential reporting environment. APRA also released a paper responding to the submissions they had received, which were generally favourable.

APRA’s prudential reporting changes

July 2010 2

The industry has largely turned its attention to APRA’s discussion paper on capital standards, but from an operational perspective these reporting changes must be dealt with first. The first (transitional) return on the new basis is due to APRA by 30 September 2010, based on the June period.

This article outlines the key changes and how they will affect insurers and users of APRA statistics. We examine the changes from the perspective of all licensed Australian insurers, with some extra detail provided for foreign branches (who may not currently prepare accounts under Australian accounting standards) and reinsurers.

(We use the term ‘AASB accounts’ to refer to AIFRS accounts that incorporate insurance related elements prepared in accordance with AASB 1023.)

At a glance

• APRA have aligned their prudential reporting with AASB financial reporting. This means that insurers will report AASB figures to APRA, with an explicit prudential adjustment to determine their APRA capital base.

• APRA have simplified the application of BBNI, which for some insurers may mean changes to their capital base position.

• The treatment of reinsurance expenses has been clarified, with two primary changes:

additional calculations to smooth out the ‘saw tooth’ effect;

guidance on how reinsurance should be allowed for and deferred, possibly affecting the capital base position of some insurers.

• The new prudential rules apply from 1 July 2010 – all insurers need to complete transitional APRA forms due on 30 September 2010, and new APRA forms from the 30 September 2010 quarter.

• Branches need to consider their approach to the changes carefully, particularly where they do not currently produce AASB accounts.

• There have been some changes that relate specifically to reinsurers.

• There are a handful of miscellaneous changes, some which will require additional work, but most of which should help save time.

• Finally, we conclude with a number of implications for insurers and the industry.

3July 2010

APRA prudential reporting aligned to AASB financial reporting

The primary effect of the changes, which came into effect on 1 July 2010, was to make APRA prudential reporting consistent with AASB financial reporting. Previously, there had been some fundamental differences between the two:

• In APRA reporting, premium income was not deferred and earned over the life of the policy, as with AASB, but was counted as revenue on the day the policy was written.

• Consequential items, such as acquisition costs and reinsurance premiums, were also allowed for on the day the policy was written (or the expense incurred), rather than being deferred. There were concessions for certain types of reinsurance – some excess of loss treaties, for example, were allowed for 50% up front and 50% half way through the year.

• APRA accounting required policies that were ‘bound but not incepted’ to be included in premium income. In contrast, as these policies had not commenced during the financial period, they were not included in AASB written premium.

• APRA accounting required a direct estimate of the cost of future claims and associated expenses, called premium liabilities.

These differences flowed through the income statement and into the balance sheet. For most insurers, the result was that APRA profits and retained earnings were quite different from AASB profits and retained earnings.

Insurers will now report their AASB measure of premium, claims, and profit to APRA, so that the net assets shown in an insurer’s AASB balance sheet should now, generally, match those found in an APRA balance sheet. Further, the statistics published by APRA will now be comparable to other industry figures.

For supervisory purposes, APRA will still require a ‘prudential adjustment’ to the AASB accounts in order to calculate an insurer’s capital base. This prudential adjustment essentially captures the current accounting adjustments between APRA and AASB accounting – so the final impact on capital base of these changes will be minimal for most insurers. However, the prudential adjustments are now clearly set out on specific APRA forms, rather than permeating the entire reporting framework.

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An example of the prudential adjustment is set out below. Firstly, consider a simple insurer, with the following year end balance sheet, along with additional items calculated for APRA purposes:

Table 1 – AASB Year End Balance Sheet

Table 2 – Other Items Calculated for APRA Returns

The insurer has net assets of 80. This is comprised of paid-up ordinary shares of 50, and retained profits of 30. Previously, the insurer would have had a separate APRA balance sheet, which would have shown different items, and a different level of retained profits. Under the new rules, the insurer starts with the AASB balance sheet, and makes a prudential adjustment to derive the APRA capital base.

The following table, an extract from APRA’s GRF 120.0 form Determination of Capital Base, demonstrates the prudential adjustment. It also extracts the calculations that are performed on GRF 210.0 Outstanding Claims Liability - Insurance Risk Charge and GRF 210.1 Premiums Liabilities - Insurance Risk Charge, since they are fundamental to the prudential adjustment calculation.

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Assets

Investments

Reinsurance

Deferred Reinsurance Expense

Deferred Acquisition Cost

Other Assets

Assets Total

Risk Margin - 75% probability of sufficiency

Premium Liabilities - Gross

Premium Liabilities - RI & Other Recoveries

LiabilitiesOutstanding Claims Liability - Central estimate

Risk Margin - 85% probability of sufficiency

Unearned Premium Liability

Other Liabilities

Liabilities Total

EquityPaid-up ordinary shares

Retained profits

Net Assets

200

30

40

10

50

330

15

50

-20

80

20

100

50

250

50

30

80

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Table 3 – Prudential Adjustment to Capital Base – Form GRF 120.0

The adjustment starts with the AASB net asset position of 80 (50 in paid-up ordinary shares, and 30 in retained earnings), and then items such as the unearned premium liability (and equivalent assets, such as deferred reinsurance expense and deferred acquisition costs) are removed (addition for liabilities, subtraction for assets), and replaced with the APRA items (these are shown as shaded in yellow in the table).

This gives a figure for the total additions to the capital base and, after income tax is allowed for, the result is an adjustment, made to the AASB net assets, which can be used to calculate the APRA capital base.

This adjustment was previously implicit. It was an outworking of APRA’s prudential reporting framework, but it was difficult to follow. Under the new reporting forms and instructions, the changes are clear and explicit.

(Note for Branches: GRF 120.0 Determination of Capital Base is not used by branch insurers, but adjustments are incorporated by using the APRA based Outstanding Claims Provision and Premium Liabilities within GRF 110.0 Minimum Capital Requirement.)

1.1. Fundamental Tier 1 capital

1.1.1. Paid-up ordinary shares

1.1.2. Reserves

1.1.3. Retained profits (AASB 1023 basis)

50

0

30

1.1.4. OCP Surplus - from GRF 210.0

Risk Margin - APRA - 75%

Risk Margins - AASB - 85%

Add 1.1.4. OCP Surplus

Total additions to capital base

1.1.6. Less Tax effect

1.1.7. Net surplus/deficit

1.1.8. Total Fundamental Tier 1 capital

15

20

5

25

-8

17

97

1.1.5. Premium Liabilities Surplus - from GRF 210.1

Add Unearned Premium Liability

Less Deferred Acquisition Cost

Add Writedowns in DAC / Unexpected Risk Liability

Less Deferred Reinsurance Expense

Less Premium Liabilities - Gross

Add Premium Liabilities - RI & Other Recoveries

Add 1.1.5. Premium Liabilities Surplus

100

-10

0

-40

-50

20

20

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Capital position changes

The changes discussed so far have been changes to reporting only, not changes in the calculation of capital requirements and the capital base. There are two primary changes, though, which may affect the capital position of insurers. They involve bound but not incepted business, and reinsurance expensing.

The (near) death of BBNI

Bound but not incepted business (BBNI) is business for which the insurer is not yet ‘on risk’, but for which risk is foreseen – for example if a policyholder has returned a renewal notice with instructions to renew, but the renewal policy does not commence until after the balance date.

Previously, APRA has required premium income to include BBNI. In contrast, AASB does not – a premium is recognised in AASB from the attachment date (the date on which the insurer is ‘on risk’).

Under the new rules, BBNI will not be included in APRA premium income. APRA and AASB premium income will the same, which will greatly simplify calculations. Previously, once insurers had estimated BBNI, they then needed to flow that business through their accounts. This meant that written premium was higher under APRA, but so were premiums outstanding and reinsurance expense on proportional and facultative arrangements. Future claims costs were calculated differently for APRA purposes and AASB Liability Adequacy Test purposes. All of these ‘flow-on’ effects, which could make APRA accounts very different from AASB accounts, will disappear.

However, APRA will still require BBNI to be calculated, and will apply the relevant premium liability risk charge to the net written premium that relates to the BBNI. This will only be required where it has a material impact on the solvency coverage – where it is not material, it will not need to be calculated.

Insurers with a significant amount of BBNI (for example, those with a common renewal date, or those who have a significant amount of broker sourced business) may find that their capital position changes. The significance of the change depends on factors such as the profitability of the business, the level of reinsurance and other recoveries, and the amount of BBNI premium that has already been received.

7July 2010

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Reinsurance expensing

APRA’s response has clarified how reinsurance is to be expensed, (i.e. allowed for as an expense), without necessarily making the process any simpler. APRA have provided 15 pages of guidance that explain how the various components of reinsurance should be accounted for in APRA’s prudential reporting.

Previously APRA did not allow the deferral and earning of premium income. On the reinsurance side, APRA required reinsurance costs to be expensed when the treaty was ’bound’. As reinsurance is often purchased once a year, this meant that insurers would need to recognise a significant expense all at once. APRA moderated this rule to some extent, allowing insurers to expense 50% of most ‘losses occurring’ treaty costs immediately, and 50% half way through the year.

This meant that on the day the reinsurance treaty was written an insurer would incur a significant cost in their APRA income statement, which would flow through to a drop in their APRA balance sheet and capital base. The end result was a ‘saw-tooth’ pattern for insurers buying a material amount of ‘losses occurring’ reinsurance.

Figure 1 – The ‘Saw Tooth’ pattern of capital

There are two issues that APRA has addressed on reinsurance expense:

Reinsurance credit to the capital base

Under the new rules, the ‘prudential adjustment’ will mean that an insurer’s deferred reinsurance expense asset will still be deducted from the capital base. However, APRA will now allow insurers to add back a proportion of the deferred reinsurance expense to their capital base. The proportion that can be added back will reduce linearly over the term of the treaty, thus smoothing out the ‘saw tooth’ pattern.

0

20

40

60

80

100

120

140

160

180

200

JunDecMonth

Capit

al Ba

se

JunDec

8July 2010

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Capturing the full deferred reinsurance expense

Some insurers create a deferred reinsurance expense asset for the whole life of the reinsurance contract. Others, for contracts where reinsurance premiums are paid quarterly, create a deferred reinsurance expense only for the next quarter.

APRA has flagged that, at least for APRA prudential reporting, they will require all insurers to fully defer reinsurance expense, on any ‘losses occurring’ contract, for the full term of the contract from the day it is written (or attaches). When the reinsurance attaches, the insurer must capitalise the full cost of the reinsurance as a deferred reinsurance expense asset. At the same time, insurers will create a reinsurance payment liability (to the extent they do not pay for the full cost of the reinsurance up front). This liability will be reduced as payments are made to the reinsurer, often each quarter, with a final adjustment premium paid at the end. The deferred reinsurance expense asset will be expensed over the term of the contract, in a pattern that follows the underlying risks, generally earned equally over 12 months.

For insurers who do not fully defer reinsurance expense in their AASB accounts, APRA will require an adjustment in their APRA forms that will essentially treat the reinsurance as fully deferred. As part of the prudential adjustment, the fully deferred reinsurance expense will be subtracted from an insurer’s capital base, and then partially added back according to APRA’s formula.

This may result in an increase or decrease to an insurer’s capital position, according to how much future reinsurance cost has been allowed for in the insurer’s premium liability calculation.

Transitional issues

Insurers are required to lodge transitional reporting forms with APRA by 30 September 2010, for their ‘financial year to date’ to 30 June 2010. These forms, under the new rules, are a cut-down quarterly return and comprise:

• GRF 900.0 - a combined Statement of Financial Performance and Position; and

• GRF 900.1 - Premium Revenue, Reinsurance and Claims Expense - an abbreviated version of the new GRF 310.1 Premium Revenue and Reinsurance Expense and GRF 310.2 Claims Expense and Reinsurance Recoveries, also incorporating acquisition and underwriting expenses.

The first quarterly returns for all insurers under the new rules will be for the quarter ending 30 September 2010 (although as noted above the quarterly return is ‘financial year to date’). Insurers will submit their first annual returns under the new rules for the financial year ending on or after 30 September 2010.

A summary of the reporting deadlines for a 31 December year end insurer are set out below:

Table 4 – Reporting deadlines - 31 December year end insurer

Branches beware!

For branches of foreign insurers, the changes may initially make life a little more complicated, rather than less.

For foreign branches that only prepare accounts on an APRA basis, there may be challenges in constructing a starting position for AASB, particularly as the form instructions can be confusing.

Where historical AASB accounts have not been prepared, restatement will be required. For example, a branch with a 31 December year end will be required to lodge the following: Transitional forms GRF 900.0 and 900.1 (as described above) under the new basis, for the period 1 January 2010 to 30 June 2010

Amongst other items, these include a Statement of Financial Performance and Position, opening and closing Unearned Premium Liability and Deferred Reinsurance Expense. These forms are due for lodgement with APRA by 30 September 2010 and are in addition to the 30 June 2010 quarterly returns to be submitted on the old basis. (Note: opening retained earnings on an AASB basis need not be disclosed at this point. However, as opening balance sheet items and current year earnings on an AASB basis are to be reported, a balance sheet as at 1 January 2010 will need to be prepared.)

Quarterly returns for the period 1 January 2010 to 30 September 2010 under the new basis

This will include opening retained earnings on an AASB basis. It will also rely on an opening 1 January 2010 balance sheet.

Essentially, the new reporting requirements under the above example will involve the restatement of the opening balance sheet and result in two 30 June 2010 quarterly returns being lodged – one on the old basis, and an abbreviated version on the new basis.

9July 2010

June quarter return

Transitional return

First quarterly return

First annual return

BasisOld

New - abbreviated

New

New

Reporting period1st January 2010 - 30 June 2010

1st January 2010 - 30 June 2010

1st January 2010 - 30 September 2010

1st January 2010 - 31 December 2010

Due date

28 July 2010

30 September 2010

29 October 2010

30 April 2011

These additional reporting requirements should be considered, and sufficient preparation time allowed. It is worth noting that while APRA have maintained the usual timeframe for the first quarterly return, they have allowed a three month timeframe to submit the transitional returns and have asked that insurers apply for extensions where necessary.

In our view insurers would be wise to spend the time between late July and late September preparing the transitional forms thoroughly and adapting their systems for the new requirements, so that the September quarter goes smoothly and they do not find themselves still ‘chasing their tails’ at the end of December.

For reinsurers

APRA have tried to consider the typical accounting practices used by the professional reinsurance companies in Australia, while making their changes, and have made a couple of amendments as a result:

• For proportional treaties, if for AASB the insurer only books premium income quarterly, then the estimated premium income for the remainder of the treaty period is to be treated as ‘BBNI’. This means that the net premium income will need to be estimated (but not booked) and a capital charge included in the MCR.

• The ‘inwards proportional premium receivable deduction’ (an arcane feature of the prospective accounting treatment) has been removed.

Other changes

There are a number of other changes that flow out of the prudential reporting changes, including:

• Where relevant, Fire Services Levy (FSL) and similar levies will be explicitly reported in APRA forms and deferred on the same basis as the related premium.

• The split between current and non-current assets and liabilities, particularly in form GRF 300.0 Statement of Financial Position, has been largely removed.

• Incurred claims costs will need to be split between ‘current period’ and ‘non-recurring’, using the method APRA prescribes.

• Underwriting expenses and acquisition costs will need to be allocated and reported across APRA classes of business.

• Some additional information on claim expense will be required in Insurance Liability Valuation Reports, and additional analysis of premium and exposure will be required in Financial Condition Reports.

• Miscellaneous simplification and clarification of the APRA forms.

10July 2010

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Summary and Implications

Summary

The prudential reporting changes will align AASB financial reporting with APRA prudential reporting quite well. While there will still be small differences, the figures that insurers supply in their APRA forms will generally be consistent with their AASB accounts. They can now follow an explicit set of steps in applying a prudential capital adjustment, rather than extrapolating from a different method of accounting. APRA have also clarified how reinsurance costs should be allowed for, which should smooth out the ‘saw tooth’ pattern of capital that the previous rules often created.

Competitor and industry analysis

APRA’s general insurance statistics show key figures for individual insurance entities in Australia, along with aggregate statistics for APRA lines of business. Until now, the statistics have been prepared on an APRA basis, making them difficult to interpret and compare to AASB and standard management accounts. These statistics will now be more meaningful and comparable, making high level competitor analysis and monitoring of industry trends easier.

Dividends

GPS 110 Capital Adequacy allows a general insurer to pay dividends up to their after-tax earnings without getting approval from APRA. To pay a higher level of dividends, the insurer must first get approval from APRA.

This requirement will remain, but the calculation of after-tax earnings will be based on the insurer’s AASB income statement rather than using APRA’s income statement. After-tax earnings will be defined as the AASB after-tax earnings in the past four quarters.

Proposed dividends will require a specific deduction from an insurer’s capital base.

Copyright © 2010 Finity Consulting Pty Limited

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Contacts

Abby Henshall abby.henshall@finity.com.au 02 8252 3373Francis Beens francis.beens@finity.com.au 02 8252 3388

Disclaimer

The article is based on our current understanding of the changes. It does not constitute either actuarial or investment advice. While Finity has taken reasonable care in compiling the information presented, Finity does not warrant that the information is correct. We refer the reader to the response paper, prudential standards, forms, and instructions on APRA’s website (www.apra.gov.au) for further detail.

Further clarification can be sought from our consultants.

Making life easier for finance and actuarial teams

Finance and actuarial teams currently need to prepare estimates of future claims liabilities on both AASB and APRA bases. In future, the figures prepared for AASB accounts will also be available for APRA purposes (with minor tweaking to ensure that the risk margins are at a 75% probability of adequacy for APRA). The changes should reduce the adjustments that were previously needed when preparing APRA forms, saving time and making errors less likely.

Although time is short Finity is considering preparing some more ‘step by step’ guidance for insurers on the changes, but this will depend on the demand. If you think you would benefit from such guidance, please contact Abby Henshall by the end of July.