On the horizon: Unpacking the new capital framework for private health insurers

The new capital framework for private health insurers (“PHIs”) is set to take effect from 1 July 2023. This follows a lengthy period of consultation by the Australian Prudential Regulation Authority (“APRA”), and marks an important milestone for the industry. 

Going forward, we expect to see issuance of regulatory capital instruments by PHIs in a similar format to those now regularly issued by life and general insurers in the Australian market. Instruments of this nature have to date been well-received by the market, with issuance taking place in both the domestic retail and wholesale markets, as well as in the international capital markets.

PHIs will also need to start complying with an internal capital adequacy process (“ICAAP”), in place of the current capital management plan requirement. APRA has emphasised that a high degree of Board engagement will be required in connection with the development of an ICAAP.

The state of the PHI industry:

It has been widely acknowledged that the PHI industry has faced structural challenges in recent years, some of which continue to persist. However, in February 2023, APRA Executive Board Member Suzanne Smith delivered a speech on APRA’s policy priorities for PHIs, in which she noted that the overall trajectory of the industry was increasingly positive, with the past two years having seen “the industry’s vital signs start to improve”. ^[1] She noted  that PHI membership growth has been on the rise for nine consecutive quarters, reflecting a renewed interest in private health coverage (potentially stemming from the COVID-19 pandemic). Moreover, PHIs have been actively exploring innovative solutions to address the challenges faced by the industry.   However, the year ending on 31 March 2023 brought a mixed bag of outcomes. Premium revenue rose by 2.6 percent, driven by a combination of increasing membership and premiums. Despite this increase, the industry experienced a notable decline of 19.6 percent in net profit after tax, amounting to $1.6 billion. ^[2]

The implementation of the new capital framework will present significant opportunities for private health insurers to undertake a comprehensive evaluation of their capital management practices and bolster their financial resilience and long-term sustainability.

The principles of the new capital framework:

The new framework is designed to ensure that PHIs “maintain an appropriate level of financial protection of policy holders”. This is said to address a concern held by APRA that the previous framework “did not appropriately reflect the risks faced by insurers or adequately allow for consideration of adverse events.” ^[3]

The new framework is based on the following key principles:

• improving the risk sensitivity of the capital standards by better reflecting the nature of risks faced by the insurer and the industry;
• limiting the differences in capital requirements by reducing insurer discretion and improving comparability between insurers; and
• aligning with APRA’s capital framework for life and general insurers (“LAGIC”), consistent with international best practice. ^[4]

A brief recap on the path to date:

The development of the new standards has been many years in the making, since APRA assumed responsibility for prudential regulation of PHIs from PHIAC from 1 July 2015.  APRA commenced consultation with industry regarding the capital framework applicable to PHIs in November 2018. ^[5]  This consultation process spanned several years. ^[6]

APRA’s Corporate Plan (2022-23), which was released on 8 August 2022 (“Corporate Plan”), identified “embedding new capital requirements for private health insurers” as one of APRA’s strategic priorities in the insurance sector. 

An overview of the new standards:

APRA has observed that the new framework “will represent a significant change for industry”. ^[7]  The new package comprises six new prudential standards, plus a series of additional reporting standards.  Copies of the new standards are available here.

Key features of the new capital framework include:

• inclusion of separate charges for insurance risk, asset risk, asset concentration risk and operational risk;
• inclusion of provision for supervisory adjustments, whereby APRA can determine adjustments to the required capital of an insurer;
• introduction of an internal capital adequacy assessment process (“ICAAP”) requirement for PHIs;
• various provisions for alignment with commencement of AASB 17; and
• improved coverage of risks outside the health benefits fund (to be achieved by applying capital charges on asset risk and asset concentration risk outside the health benefits fund and managing risks related to non-insurance businesses via the ICAAP).

Notably, the new HPS 112 incudes definitions of Tier 1 Capital and Tier 2 Capital of PHIs, and criteria for classification of instruments issued by PHIs in the various tiers of capital.  HPS 112 includes requirements that are familiar from the LAGIC framework for loss absorption at the point of non-viability in instruments that are classified as Additional Tier 1 Capital or Tier 2 Capital.  It also requires Additional Tier 1 Capital and Tier 2 Capital to be classified as accounting equity and liability of the relevant health benefits fund respectively. ^[8]

In response to feedback from the consultation process, the final standards will include provisions designed to enable mutually owned PHIs to issue capital instruments that are convertible into mutual equity instruments (“MEIs”). ^[9] The MEI provisions are intended to track the similar provisions currently included in ADI prudential standards. ^[10]

APRA has included some transitional provisions in the finalised standards to assist smaller PHIs to commence complying with the standards.  These transitional arrangements were added following feedback received as part of the consultation process. ^[11]  In summary, smaller PHIs will be eligible for:

• a two-year transition period to meet the new Prescribed Capital Amount (“PCA”) and capital base requirements (subject to eligibility requirements); ^[12] and
• a two-year exemption from the new ICAAP requirements.

APRA will use the Significant Financial Institution (“SFI”)/Non-SFI distinction currently included in various prudential standards to identify “smaller” PHIs for these purposes. In the case of PHIs, an insurer will be considered a SFI if it has total assets in excess of $3 billion or is determined to be such by APRA. ^[13]  

Quantitative impacts of the new standards:

APRA has undertaken a Quantitative Impact Study (“QIS”) in connection with the new framework.  Notably, the QIS indicated that the new standards:

• would not require any insurer to need additional capital to meet the PCA; and
• resulted in most insurers having reasonable capital buffers above the PCA. ^[14]

APRA also indicates that it considers the PHI industry to be “well capitalised”. ^[15]  Despite concerns raised by some insurers as part of the consultation process, APRA has indicated that it does not expect the new standards to “provide a basis for increasing premiums”. ^[16]

Key points for Boards:

APRA’s Corporate Plan notes that it intends to “develop a handbook for Board directors to support them in better understanding their obligations”. ^[17]  The development of this handbook forms part of a broader APRA initiative targeted at modernisation of the prudential architecture. 

Consistent with this theme, the Information Paper accompanying the new standards includes a description of key points to be considered by Boards in implementing the new standards.  APRA regards responsibility for the ICAAP lies primarily with the Board and notes that it “expects Boards to take the implementation of a new capital framework as an opportunity to undertake a comprehensive assessment of the way in which they oversee capital management, and gain assurance that capital is sufficient for this risk”. ^[18]  While senior management, including the appointed actuary may be involved in developing the ICAAP, it is crucial for Boards to actively engage in its development and oversee its implementation on an ongoing basis.

At a minimum, PHI Boards will need to have specific involvement in setting the ICAAP under the new standards.  HPS 110 provides that the ICAAP must be approved by the Board of a PHI when first adopted (and Board approval is also required “when significant changes are made”). ^[19]  The Response Paper contains further detail on APRA’s expectations for Boards in this regard, noting that APRA expects Boards to:

• undertake a thorough assessment of the PHI’s risks (and risk appetite) in developing the ICAAP;
• robustly review and challenge assumptions behind the ICAAP; and
• consider and articulate the PHI’s “appetite for the possibility of breaching regulatory capital”. ^[20]

Key takeaways

• From 1 July 2023, new capital standards will apply to PHIs. These will prescribe capital requirements in terms that are similar to those that apply under LAGIC. Importantly, the Australian domestic capital market has an investor base that supports issuance of by insurance companies in the LAGIC format. The alignment of the PHI and LAGIC standards creates an opportunity for PHIs to access funds from investors familiar with the terms of these instruments. 
• Boards of PHIs must take responsibility for implementation of an ICAAP and not treat it as a mere “tick the box” exercise. Implementation of the new capital framework will provide PHIs the opportunity to perform an in-depth assessment of the way in which they oversee capital management.