Matters of judgment
Australia's approach to insurance regulation has won admirers. Europe is watching closely. David Keefe meets Apra's Tom Karp
"The HIH experience was a formative one - and it reinforced the lesson that supervising financial firms is as much about judgment as measuring risk," says Tom Karp, executive general manager at the Australian Prudential Regulation Authority (Apra).
Karp now heads Apra's Supervisory Support Division, responsible for technical, actuarial, specialist risk and legal services - and also enforcement.
But on March 15, 2001 he was executive general manager of what was then Apra's Diversified Institutions Division when the HIH Insurance Group, Australia's second largest general insurer, collapsed in the country's biggest bankruptcy.
The subsequent Royal Commission of inquiry was scathing about most of those involved with HIH, including Apra which had assumed responsibility for supervising insurers in July 1998 on the agency's creation as Australia's integrated financial sector solvency watchdog.
The Commission said Apra did not itself cause or contribute to the collapse of HIH, which went down for Aus$5.3 billion (US$4.1billion; €3.2 billion) amid a management culture of apparent indifference or deliberate disregard of the well being of the company. And the agency was misled as to HIH's true financial and solvency position.
Not just the balance sheet
Reflecting on the events four years later, Karp says: "At the end of the day, a lot of what you do is to make a judgment about the business of the institution you're supervising and the people who run it. The numbers - the balance sheet, the capital calculations, the risk measurements - are basic and must be analysed. But in a sense they're secondary to the judgments that need to be made about the underlying state of the business and the quality of the people running it."
Since taking up his current job in July last year, Karp's responsibilities have broadened. He reports, like the heads of the other three regulatory divisions, to Apra's three-man executive group.
But Karp is an actuary by profession, spending 15 years in commercial insurance before joining the former Insurance and Superannuation Commission, later subsumed into Apra, in 1989.
He chairs the technical committee of the International Association of Insurance Supervisors (IAIS), the Basel, Switzerland-based body that represents insurance regulators from 180 jurisdictions with the aim of setting international standards for insurance regulation.
The technical committee is the body that develops the international standards. In February the IAIS issued its "cornerstones" for assessing insurer solvency, which built on its new framework for insurance supervision published in October.
Anything like an international insurance solvency accord on Basel II lines, with detailes rules for capital calculation, is a distant prospect, says Karp.
But the IAIS aim is to encourage the use of broadly similar methodologies, and less opaqueness generally, so that while regulatory differences will continue to exist in different countries, they will be able to be understood and accurately compared by regulators and firms in other countries.
Australia's risk-based solvency regime for insurers, which dates from 2002 for non-life insurers and from 1995 for life insurers, is proving a magnet for regulators elsewhere seeking to update their rules.
The European Union's Solvency II project for improving the safety insurers is expected to contain elements of the Australian model, according to Paul Sharma, head of banking, insurance and investment policy at the UK Financial Services Authority.
Getting Europe's attention
In particular, Apra's approach to valuing insurance contracts - the insurance policies sold to customers that form the bulk of an insurer's liabilities - is attracting attention in Europe, given the delay in the efforts of global accounting rule-makers to agree a standard for insurance contracts as part of the new international accounting rules known as International Financial Reporting Standards (IFRS). The European Commission, the EU's executive arm, had hoped to use IFRS insurance standard as the basis for valuing insurance policies for regulatory capital and solvency requirements.
Karp says Australia's approach is based on a realistic assessment of profitability with a conservative solvency and regulatory framework."We've been able to create a marriage between fair value - the measuring of assets and liabilities are current market prices - and risk-based regulation," Karp says.
The problem with insurance policies is that valuing them at current prices is difficult because there is no liquid secondary market to give prices for the contracts.
The Apra approach uses a best estimate of the value with an adjustment for risk.
A solution includes the possibility of a cost-based measure, instead of than fair value. The delay has left staff with the European Commission, the EU's executive arm, with the task of developing their own approach, while trying to anticipate future IFRS work. "We prefer market-value accounting - it sends the right signal to managers," says Karp.
Under Apra rules the valuation of liabilities for each class of general insurance business, for instance, comprises a central estimate of the outstanding claims, a central estimate of the premium liabilities plus risk margins "that relate to the inherent uncertainty in each of these central estimates".
The central estimates are generally measured as the present value of the future expected payments, discounted by market-based and objective interest rates - a process involving prospective calculations and modelling techniques.
The risk margin is set to secure the insurance liabilities of the insurer at 75% sufficiency, which for many portfolios is about one standard deviation above the mean.
