Insurer Bail-Outs - Should Australian Policy Holders Be Concerned?

In the wake of the US Federal Reserve's US$85 billion bail-out of AIG, Australian policy holders may understandably be concerned about the security of their own insurance arrangements.

In light of recent events and the shock waves being felt by insurers as a result of the sub-prime crisis, it is timely to consider the policy holder protections in place in Australia. Local insurers and branches of foreign insurers authorised to conduct insurance business in Australia are required to comply with strict capital requirements imposed by the Australian Prudential Regulation Authority (APRA). Protections also exist under the Insurance Act and Corporations Act in the event of an insurer's or reinsurer's collapse.

Following the collapse of HIH in 2001, APRA bolstered its prudential standards in an attempt to ensure that funds will always be available to meet claims. Although the causes and effects of the sub‑prime crisis are quite different, they may have the potential to test how robust APRA's measures are to safeguard against insurer collapses in Australia. APRA has already indicated that it is closely monitoring insurers to gauge the effect of the current crisis.

Even if most or all insurers survive the crisis, an end to the recent soft market seems likely, resulting in increased premiums - particularly in relation to financial lines (e.g. directors' and officers' liability insurance). The current uncertainty may also have an impact on insurers' attitudes to claim payments, another factor to consider upon renewal.

Protection for policyholders (Insurance Act 1973; Corporations Act 2001; and APRA's Prudential Standards)

Section 28 of the Insurance Act 1973 (the Act) requires all general insurers authorised in Australia to maintain assets in Australia of a value that equals or exceeds the total amount of the general insurer's liabilities in Australia. This requirement is designed to ensure that the total value of assets held within the jurisdictional reach of the Australian courts is sufficient to meet the general insurer's liabilities in Australia for the purposes of subsection 116(3) of the Act.

Section 116(3) seeks to ensure that in the winding up of a general insurer, the insurer's assets in Australia are not to be applied in the discharge of its liabilities other than its liabilities in Australia unless it has no liabilities in Australia.¹

Further comfort is afforded by a recent House of Lords decision² which affirmed the application of Australian law to English subsidiaries of HIH requiring reinsurance proceeds to flow directly through to claimants. Section 562A of the Corporations Act 2001 provides that if an insolvent insurance company has reinsurance, the proceeds of such reinsurance are to be distributed to holders of the relevant insurance policies prior to the general pooling of the insurer's assets. However, these provisions have not been tested against equivalent US legislation.

Section 32 of the Act also empowers APRA to determine prudential standards. APRA provides standards in relation to an insurer's Minimum Capital Requirements (MCR) for locally authorised insurers (including locally incorporated subsidiaries and foreign owned branches). The key APRA standards are those relating to capital adequacy (GPS110-116) and those that provide for the determination of assets in Australia (GPS120).

Minimum Capital Requirements

APRA provides a risk-based approach to the measurement of an insurer's capital adequacy. The insurer's capital base must be adequate for the scale, nature and complexity of its business and its risk profile. An insurer may elect to use an internal based model (IBM), the standardised framework provided by APRA, or a combination of both.

An insurer's IBM Method must be approved by APRA. In particular, APRA must be satisfied that the model is well designed, the analysis and assumptions used are sound, and that the results of applying the model are reasonable from a prudential viewpoint. APRA may adjust an insurer's IBM determination. In formulating this adjustment, APRA may take into account all relevant matters including whether the insurer is in, or appears likely to be in, financial or operational difficulty.

APRA's own prescribed method for MCR calculations involves a determination of the sum of capital charges for the insurer's insurance, investment and concentration risks. The insurance risk relates to the actual value of net insurance liabilities. The investment risk capital charge relates to the risk of adverse movements in the value of an insurer's assets or off-balance sheet exposures or both.

Recent changes to APRA's prudential standards have introduced various categories of insurers with varying prudential requirements. Branches of foreign insurers authorised in Australia, as opposed to local insurers or local subsidiaries of foreign insurers, fall within category C. Although there is a degree of ring‑fencing of assets, there is slightly more leeway in relation to the capital calculations and some local branches of foreign insurers regularly repatriate capital so as to only maintain the minimum capital buffer.

Given events outside Australia, recent legislative amendments restricting the ability of unauthorised foreign insurers to conduct business in Australia may now be welcomed. However, increased capital charges associated with reinsurance recoverables from non-Australian authorised reinsurers may further strain local insurers' capital.

Rating agencies

Recent events also cast a shadow over the reliance placed on insurer ratings, given AIG's still relatively healthy rating in the weeks leading up to the bail‑out. The crisis also demonstrates how dependent insurers are on rating agencies given that a downgrade can trigger not only a collapse in an insurer's share price but also the need to raise significant additional capital.

For larger insurance programs, diversification of insurers may also afford additional protection by limiting exposure to the financial fortunes of a single insurer. In the past there was some benefit in placing large tranches of cover with a single insurer (e.g. volume discounts, relationship building and simpler claims handling). It will be interesting to monitor whether this practice continues.

Further reforms – the financial claims scheme

In addition to the above implemented reforms, Australia's federal government is considering protecting consumers in the wake of the global credit crisis by establishing a Financial Claims Scheme (FCS) that gives depositors of banks and policyholders of insurers quick access to funds should a financial institution fail. However, these proposals are aimed at the retail end of the market.

On 2 June 2008, Treasurer Wayne Swan announced that the Rudd Government would implement legislation intended to mitigate the potential repercussions on Australian policy holders due to turbulence in global markets. This mitigation would be in the form of the FCS to assist depositors and policy holders in the event that a general insurer (or authorised deposit-taking institution) fails.

In order to provide timely access to funds, claimants will be able to immediately recover monies up to a specified cap ($20,000 per person). The FCS will also endeavour to provide compensation to policy holders who have valid claims with a failed general insurer, with costs being recovered through the liquidation process. Any shortfall would be borne by the relevant financial institutions in the form of levies.

Conclusion

While insurers can take some comfort from APRA's stronger prudential regulation of locally authorised insurers and requirements to maintain assets in Australia, such protections may be tested by recent world events. Protections are also in place to maximise the ability of Australian policy holders to gain access to funds in the event of claims, even at the point of an insurer's collapse.

However, with insurers facing a more hostile claims environment whilst their investments decline, it is likely that the current soft market conditions, particularly in relation to financial lines, will come to an end producing increased premiums and/or a narrowing of cover.

Developments in the coming weeks and months will no doubt be closely monitored by all concerned.

Footnotes

1 The High Court recently considered what is a liability in Australia in AssetInsure Pty Ltd-v-New Cap Reinsurance Corp Limited (in Liq) (2006) 225 CLR 331

2 HIH Casualty & General Insurance Limited Re: McGrath v Riddell [2008] 3 ALL ER 869

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.