Australia: Potts Report Proposes Further Insurance Reforms

• Treasury released the long awaited Potts Report into the regulation of Direct Offshore Foreign Insurers and Discretionary Mutual Funds on 27 May 2004.
• The Report recommends that DOFIs marketing insurance in Australia should remain exempt from prudential regulation in Australia if they are domiciled in a country with comparable regulation.

The Potts Report was commissioned as a response to the HIH Royal Commissioner's observations on Direct Offshore Foreign Insurers ("DOFIs") and growing concern over the protection of less "sophisticated" parties seeking cover from DOFIs.

Foreign insurers can currently sell insurance to Australians directly, or via insurance agents or brokers licensed in Australia, without establishing a subsidiary or branch in Australia. Such foreign insurers are known as DOFIs and escape the provisions of the Insurance Act.

Some argue that this puts local insurers at a competitive disadvantage as DOFIs need not be regulated or authorised in another jurisdiction (or their local regulator may have more relaxed requirements). DOFIs can also operate without complying with Australian capital adequacy requirements and are not subject to Australian accounting standards or any other uniform financial reporting requirements. The compliance costs of DOFIs may therefore be significantly less than those for their Australian competitors.

Consumers may also be exposed as the enforcement of any judgment by an Australian court against a DOFI can be difficult and therefore DOFIs may seek to avoid the operation of Australian consumer protection legislation.

Such concerns are highlighted by the recent winding up of a DOFI licensed in the Solomon Islands. On 2 June 2004, ASIC obtained orders to wind up International Unity Insurance (General) Ltd ("IUI") and its Australian agent after ASIC became aware of IUI's failure to pay insurance claims and policy refunds amounting to over $1 million. The win allows Australian consumers who have unresolved payments from IUI to at least obtain a share of the realised assets (if any) of IUI.

Nevertheless, in the current hard insurance market DOFIs play a valuable role in providing capacity and not all DOFIs pose the same level of risk. Most are reputable insurers operating through well established local agencies. In recent times community groups, small businesses and professional associations have relied heavily on DOFIs to provide cover due to a perceived lack of affordability of cover from local insurers.

However, it is for these groups that an increased level of protection is advocated as opposed to the specialist markets and large scale corporate operations (eg. aviation) where DOFIs are traditionally utilised. Accordingly, although only comprising 2.5% of the general insurance market, the need to get the balance right has been strengthened by the increased sensitivity of the market within which DOFIs operate.

The key findings of the report in relation to DOFIs are as follows:

• Allow DOFIs marketing insurance in Australia to be exempt from prudential regulation in Australia if they are domiciled in a country APRA considers to have comparable prudential regulation, subject to a market significance threshold to prevent established authorised insurers moving offshore. DOFIs not meeting this test would be able to market insurance in Australia as an authorised insurer, through a branch or subsidiary.
• Give APRA enhanced enforcement and investigative powers to establish whether the nature of a DOFI's operations is such as to require authorisation under the Insurance Act, subject to satisfactory safeguards.
• APRA to assume a data collection role in relation to offshore insurers.

These measures were deemed advantageous in that they left untouched the bulk of DOFIs while forcing those deemed outside the comparable regulation requirement to seek authorisation under the current APRA regulatory scheme for foreign insurers, effectively bringing them within the tighter regulatory framework of domestic law.

The Treasurer has indicated that the recommendations have been accepted and will be implemented.

The key findings can best be described as minimalist. While ensuring that capacity will remain from the major DOFIs, there is no recommendation of enhanced disclosure to consumers to warn them of the risks associated with DOFIs. Rather, the onus has been placed on APRA to weed out any inadequately regulated or unscrupulous operators. It remains to be seen which countries APRA will deem to provide "comparable prudential regulation".

The Insurance Council of Australia has also observed that the report does little to help enforce a balanced protection mechanism for those seeking insurance from DOFIs. The proposals do little to create a more level playing field for local insurers who are subject to arguably the strictest prudential controls in the world, high capital costs and local taxes on insurance. On the other hand, the recommendations should ensure that there is no significant drop in the capacity provided by DOFIs.

The gap (in relation to wholesale insurance products where no PDS is required) left by the repeal of the Insurance (Agents & Brokers) Act 1984 (the Corporations Act does not include a requirement for wholesale products that notice be given if cover is placed with a DOFI) has not been addressed. Arguably, if there is a need for consumers to utilise DOFIs, the most crucial protection mechanism is disclosure so that consumers are aware of the risks. If insurers that operate from comparable markets are still flagged as potentially greater risks than domestically regulated insurers, the insured must make a commercial decision whether to accept such risks.

As the Federal Government chose not to bail out foreign policyholders in the case of the HIH collapse, it is unrealistic to expect foreign Governments to bail-out Australian policyholders should a DOFI collapse. Without increased education or consumer protection (DOFIs can arguably escape the consumer protection afforded under the Insurance Contracts Act), there remains the possibility that relatively unsophisticated consumers will be exposed to the increased risks posed by DOFIs. The report seeks to address such concerns by ensuring that all DOFIs are adequately regulated so as to remove the need to warn of any risks associated with DOFIs.

Further consumer protection issues, as highlighted by the HIH Commission, are now more likely to arise in the Policyholder Protection Scheme debates following the release of the separate Davis Report on financial system guarantees.

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