Risk.net: Australia weighs up illiquidity premium for insurer liabilities

08 June 2012

Australia is forging ahead of the rest of Asia in introducing risk-based capital regulation for its insurance industry with the recognition of an illiquidity premium. Could this in turn lead to a solution to Australian banks' Basel III liquidity issues?

It is not just the banking sector that is trying to get to grips with risk-based regulation in Asia. As the Basel III framework has been rolled out across the region, regulators in some of these countries have started to turn their attention to the life insurance industry.

Most jurisdictions in Asia still adhere to solvency regimes where capital reserves are calculated on a basis that has little to do with companies’ actual risk profiles. A number of countries – including Singapore, Japan, Indonesia, the Philippines and Taiwan – have moved to some variation of a risk factor-based model, similar to that found in the US. Under this approach, liabilities are discounted at non-market rates and then adjusted by weighted factor, according to their perceived sensitivity to risk.

Three countries – Japan, Singapore and Hong Kong – have given some indication that they may consider adopting a mark-to-market, risk-based capital (RBC) approach. But discussions are very much at an early stage, with little sign that significant changes are going to be made any time soon.

Only Australia, one of the more developed markets for life insurance in the region, has wholeheartedly embraced a fully risk-based capital regime. Known as the Life and General Insurance Capital (LAGIC) standards, the regime has close parallels to Solvency II – the European Union RBC initiative, slated to come online in 2014. In fact, Australia is one of seven jurisdictions in the latest wave of countries being assessed by the European Insurance and Occupational Pensions Authority (EIOPA) – as having an equivalent regime to Solvency II.

Within Australia’s RBC framework, however, there is an important dilemma that needs to be addressed. Like regulators in Europe, the Australian Prudential Regulation Authority (APRA) is trying to work out what to do about long-term liabilities of life insurers, which, while technically illiquid, are not immediately callable by policyholders.

At the end of March, it gave its clearest indication yet of what a future ‘illiquidity premium’ – the additional amount that can be added to the discount rate when valuing long-term illiquid liabilities – might look like.

In its proposal, which is now open for consultation, APRA has opted for a formulaic approach. For the first 10 years, the illiquidity premium will be calculated by adding 15 per cent of the A spread on government bonds to 15 per cent of the double-A spread (as determined by Standard & Poor’s credit rating agency), with a maximum value of 150 basis points (bps). Beyond 10 years, the illiquidity premium will be set at 20 bps.

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