1 May 2001

Speech to the APRA General Insurance Reform Conference, Sydney

Thank you Brian.

Thank you for inviting me to speak to you today on the Government's commitment to reform of the general insurance industry.

These reforms which have been out for consultation with the insurance industry and APRA since 1998, will be the first significant reform of the general insurance industry in nearly 30 years.

Of course the reforms are timely, particularly in the light of the recent significant commercial losses of GIO Australia, New Cap Re, ReAC and, of course, HIH.

I will come to HIH in one moment however, I first wish to touch on the need for reform.

As most of you will be aware the Government adopted the recommendations of the Wallis Report in late 1997.

Whilst some financial service industries like life insurance had been reformed in 1995, key parts of this report recommended the further reform of banking and the set up of new independent regulators.

Since 1998 we have set about implementing the Report.

We have centered Government regulation around three agencies based on practical product lines as distinct from traditional institutional lines.

Each agency was granted substantial autonomy and a clear charter of objectives with mechanisms aimed at ensuring effective co-ordination between agencies.

The Reserve Bank's role was re-defined to focus primarily on monetary policy, overall financial system stability and regulation of the payments system.

The Australian Prudential Regulation Authority was set up to undertake the prudential regulation of deposit taking institutions, life and general insurance companies and superannuation funds.

The Australian Securities and Investments Commission was established to maintain market integrity, information disclosure and overall consumer protection.

These changes aimed to produce an effective regulatory system for dealing with financial conglomerates such as combined banking, insurance and superannuation companies.

They also provided scope for greater regulatory consistency across institutions undertaking similar activities. And most importantly, they provide a better-focused, more accountable structure for protecting Australian consumers.

Banking reform has been completed with amongst other things the transfer of building societies and credit unions from State supervision to a national scheme. The reforms also facilitate the conglomeratisation of financial service providers so they can offer consumers more than traditional banking or traditional insurance products. The final tranche in the reform is the introduction of the Financial Services Reform Bill earlier last month.

Whilst the prudential supervision of superannuation remains an area in need of further reform the priority of all parties since the formation of APRA has been in general insurance.

The Australian general insurance industry comprises 163 private sector and 15 public sector general insurers. It earns over $15 billion of premiums each year. And it pays claims of $12.2 billion every year.

It goes without saying that the general insurance industry represents a significant part of the Australian economy, not only in size but also through its major role in related investments.

General insurance is however, also a unique industry because it pools economic risk and also manages economic losses collectively.

I can think of no more complicated operating business than a general insurance company. It's not like manufacturing where physical inputs are bought, assembled and packaged for marketing.

General insurance companies have all that but every product they sell is unique because it will either protect a unique situation, a unique product, or an event occurring in a unique place or a combination of all of the above.

For example, a basic home and contents policy in Ballarat will be different to a policy in Bankstown. They will have different risk profiles, different premiums, may be written by different companies and may be insuring different products.

Therefore of the 38 million private sector policies in Australia its unlikely that any two policies would be identical.

Whilst some insurers obviously rely on their investments and premiums for income they also hedge their claims risk by buying reinsurance. This insurance of insurance should provide some protection for the Australian insurance industry and policyholders accordingly.

Some companies have engaged on the potentially risky path of writing inward reinsurance from overseas. This line of business came at some considerable cost to GIO, ReAC and New Cap Re.

However, most prudent insurers write outgoing reinsurance to lay off some domestic risk.

In something generally similar to banking and some other financial service providers, general insurers must manage all of the difficulties of estimating future liabilities and, needless to say, the equation becomes very complicated.

Apart from these factors general insurance also involves sophisticated financial management of both assets and liabilities. Companies must combine all of the skills of professional asset management with prudent investment strategies. Not all companies have had noteworthy success to date.

So, with this background it is little wonder that the general insurance industry has needed reform - a prospect which all Governments until ours have put in the "too-hard basket" since the Insurance Act was introduced in 1973.

Today insurance products are more complicated than ever. Investments are more complicated than ever. Reinsurance is more complex than ever and the price of failure is greater than ever.

Reforming the general insurance industry has been a key part of the Coalition's financial sector reform agenda.

In August 1998 APRA announced its intention to review the capital adequacy and solvency requirements for general insurers. It also set about reviewing transparency and general insurance reporting issues.

In March 1999 APRA hosted a seminar and delivered information to the industry on its proposed reforms and the Insurance Council started working with APRA on these requirements.

In September 1999 APRA delivered 3 policy discussion papers and during 2000 it had a second round of consultations.

In October 2000 I received unanimous support in Cabinet for the proposed reforms, and when I announced the changes the Government's intention to proceed received scant media coverage.

I would now like to highlight briefly how these changes proposed by the Government last November would change the general insurance industry.

One of the key problems in some general insurance companies has been the temptation to significantly undervalue insurance liabilities.

Insurance liabilities, being the amounts owed to policyholders on past and future insurable events, make up a large component of an insurer's balance sheet. They can be highly volatile due to the uncertainty surrounding the likely magnitude and timing of claims.

Under the current arrangements, a potential lack of objective criteria for calculating liability provisions allows companies to set these provisions according to their own particular attitudes to profit reporting, risk appetite and tax effects.

This results in inconsistencies between individual insurers, so that both the regulator and the market are unable to adequately assess the risk-adjusted strength and ranking of each company. This can have grave consequences.

The purpose of the proposed Liability Valuation Standard in the new regime is to ensure that the insurance liabilities of all insurers are measured and reported consistently on a basis which is appropriate within the context of the market value basis used for valuing assets.

In addition, the proposed requirements will substantially strengthen the capital adequacy requirements for general insurers.

Currently, the solvency requirements do not distinguish between the riskiness of business undertaken, and incorrectly assume that all companies have the same mix of business. For some general insurance companies with significant long-tail liabilities, the current capital requirements are clearly inadequate.

The new requirements will substantially increase the responsibilities of the board and management of an insurer and require them to get advice of independent experts, such as actuaries, in the management of their companies.

This should increase the transparency of the decision making process and help ensure the information received by the board is an accurate reflection of the company's position.

The new regime, with its flexible three-tiered legislative structure, will allow the prudential regulation to rapidly and flexibly adjust to market and technological developments in the financial sector.

This will ensure it does not become outmoded over time as has happened with the current regime.

This flexibility allows the domestic regulatory structure to encourage domestic players to take on world's best practice. In a changing environment, this can provide significant competitive advantages.

With most of the details now settled, we can begin to focus on the process of implementing the new regime. The Government is expecting to introduce the amendments to the new General Insurance Act during the Winter 2001 Parliamentary sittings, which finish in June.

If all necessary legislation is passed by the end of this year and the prudential standards are settled, we would like to see the new regime start as soon as practical.

I should advise you that the Insurance industry has, until recently, resisted any expedited timetable for reform, claiming such radical change must be inmplementred over a longer timeframe.

This is partly because the reforms will cause a restructuring of assets and liabilities in this huge industry. Moreover, it is expected that a number of insurance companies will need to either restructure, merge, raise significant new capital or take other measures to meet the new requirements.

Whilst reform may be painful for the general insurance industry, given recent events, particularly involving HIH, the Federal Government will no longer tolerate industry resistance to stronger prudential requirements.

We are looking at expediting the timetable previously announced and, as such, we are consulting the industry.

The Government's role is not to micro manage Australian companies. We do not have the capacity or expertise to sit in the boardroom of every Australian company.

Accordingly, our prudential regulator APRA does not guarantee the commercial success or the financial future of general insurance companies.

APRA's job is to set standards and do its best to ensure that companies comply with those standards.

The ultimate responsibility for the prudent operation of all financial institutions rests with the management and board of each institution itself. Others, like the company auditors, also have a significant role to play.

Today's prudential arrangements are inflexible and outdated and for a number of reasons they must now be replaced.

Having said that, the general insurance industry in Australia is, I am advised, in good health. Most companies are well provisioned and are well run.

However, public confidence in the general insurance industry is low following the collapse of HIH.

This is understandable.

HIH was Australia's second largest general insurer. It had more than 2 million policies issued to more than 1 million policyholders.

Its last audited annual report for the year to June 30 2000 indicated a company with net assets of over $960 million.

In the words of the provisional liquidator the company was at best "marginally solvent" at 15 March 2001 and by 11 April 2001 the Provisional Liquidator had formed the view that the company was "clearly insolvent".

Obviously the provisional liquidator's assessment of 11 April that "the very substantial losses which will be revealed will not be restricted to the last nine months of operation" is telling.

However, it is not for the Government, at this stage, to give a running commentary on as yet unresolved reasons for the demise of HIH.

We are most sensitive to the plight of policyholders who relied on HIH for protection.

The Government and the regulators are responding to the HIH collapse on 3 fronts.

First, APRA has an inspector in place at HIH and, at the advice of the regulator, I have agreed to APRA issuing directions under the Insurance Act to ensure the company's assets are preserved for the benefit of policyholders and creditors.

At this time the inspector is reporting regularly to APRA on the state of HIH as its true financial position unfolds.

Whilst during late 2000 it was clear that HIH was facing significant financial difficulties there was no indication of the full extent of the problems.

However, during this period APRA worked with HIH to implement a series of joint ventures and sales that would protect many of HIH's policyholders. These arrangements with Allianz, QBE Insurance and NRMA have also allowed for the realisation of extra assets which enhance the security available to meet all policyholders' claims.

For example, the joint venture with Allianz, which crystallized the value of the ongoing business of HIH retail products, saved over one million customers from the uncertainty and insecurity of the insurer's collapse.

Moreover QBE deserve credit for their immediate protection of domestic and overseas travelers with HIH insurance who may not have been able to meet the cost of medical emergencies immediately after the provisional liquidator was appointed.

Those policyholders and beneficiaries in the statutory classes of workers' compensation and Compulsory Third Party (CTP) insurance will also be protected by State and Territory arrangements already in place.

The problem for HIH and others in these areas of insurance is that a different scheme exists with different regulations in each State.

It is the Commonwealth Government's view that individual State Governments must take responsibility for the guarantees that they have made with CTP insurance and Workers Compensation.

It is unacceptable for a State like NSW to structure their schemes differently to other States and then expect the policyholders of other companies in other States to fund their problems.

I refer Premier Carr to the actions recently taken by the West Australian Government to address the HIH induced shortfall in its workers compensation scheme with a statutory levy of 5% on premiums.

Clearly State Governments must take responsibility for their own mandated insurance schemes.

There also has been much media speculation about Builders Warranty insurance. The Builders Warranty schemes vary from State to State.

Some States, like Queensland, guarantee the scheme. Therefore, the taxpayers of Queensland are supporting the Queensland mandated scheme.

Others like the Northern Territory have no scheme at all.

In NSW and Victoria there are different schemes again and those State Governments must stand behind those compulsory builders warranty schemes.

In the meantime, I am advised that there are two other insurance companies that offer builders' warranty insurance ┬ľ Royal and Sun Alliance and Dexta, as an agent for Allianz.

Two problems have emerged in relation to Builders Warranty. First, builders have had to give HIH a bank guarantee which the provisional liquidator will not as yet release.

Second, Royal and Sun Alliance and Dexta have had difficulty dealing with the huge demand for their policies. APRA advise me that they have been working with these companies to ensure that they are providing replacement cover on building work on similar terms to those available to former HIH policyholders.

The Government is also concerned for salary continuance policyholders. Whilst Centrelink has moved quickly to support those most vulnerable many of those policyholders are enduring severe hardship.

The provisional liquidator and the Insurance Council have advised me that they are dealing with those approximately 300 cases on a case-by-case basis ensuring that if a liability exists with a former employer or perhaps a super fund then all avenues for support are utilised.

In the interim APRA is attempting to obtain more information about the scale of this issue.

Naturally, the Government is most concerned for those policyholders enduring hardship as a result of the collapse. Whilst the provisional liquidator still has not quantified either where liability lies or the scale of the problem, we are closely monitoring progress and are working on options.

The worst outcome at the moment would be for the Government to become directly involved in this matter without care. It could have significant ramifications on reinsurance and legal liability if we acted without caution.

Liability for financial risk must lie where the contractual obligations lie. Moreover, no one can quantify the size of the losses and it would be a foolhardy Government that would seek to solve a problem without being able to quantify the size of that problem first.

The second part of our approach involves ASIC undertaking wide investigations into possible breaches of the Corporations Law, including trading while insolvent, appropriate market disclosure and corporate governance generally.

I am advised that ASIC is aggressively pursuing answers to questions including the role of the directors and the auditors of HIH. I have been given a commitment by ASIC that no resources will be spared in the pursuit of these matters.

It is not trite to remind this audience that directors owe a very high fiduciary duty of care and this is a cornerstone for market confidence in our investment environment.

I am particularly concerned with the need for good corporate governance in Australia. This is something I addressed in detail in a speech to the Sydney Institute on this day last year.

Insurance, generally has performed reasonably in this regard however, given recent events I have asked both ASIC and APRA to pay particular regard to the current board and management instability at NRMA.

NRMA is Australia's largest general insurer. While APRA advise me that there is no prudential concerns with NRMA, I am concerned that recent board infighting is doing damage to NRMA and damage to the general insurance industry.

Ladies and gentlemen, in summary I want to make one point very clear - the roles of APRA and ASIC in the investigation of HIH are ongoing.

These regulators are focussed on getting the best possible outcome for policyholders. As a consequence, and in response to the growing blame campaign on HIH, now is not the time for us to be giving a running commentary on the regulators in the form of a review.

It is inappropriate to be using resources currently dedicated to protecting policyholders interests for a review of our regulators when policyholders are still exposed and their rights are still uncertain.

Finally, the failure of HIH has raised a number of issues and will certainly raise more as the provisional liquidation proceeds.

To ensure the Government is fully briefed and options are assessed the Government has established a high level taskforce Chaired by an Executive Director from the Treasury with high level representation from APRA, ASIC and the Attorney General's Department. It will advise myself and Cabinet on matters relating to HIH.

At this time we are all waiting for the provisional liquidator to provide us with more information about the true state of HIH.

There are however some general questions in relation to HIH that should be asked. Did HIH fail because it insured some people who should never have been insured? Were its premiums too low, its investments poor and its commissions to brokers and agents too aggressive?

Everything is speculation without a true picture of the company. On the basis of information provided to date no one should assume that these questions have easy answers. Whilst the line of accountability is clear no one here was sitting in the boardroom when those questions should have been asked.

Ladies and gentlemen, regulation is a continuously evolving and improving process.

The reforms to the general insurance industry, which are before you today, will bring our regulatory framework to the highest world standard. They are overdue.

Given more recent events I now ask you to change your views and I encourage all of you to work with APRA for a speedy implementation.