APRA backs risk-sensitive illiquidity premium

Insurers and other manufacturers of longevity products will pay a price for the use of unrated and privately rated assets under a new approach outlined by the Australian Prudential Regulation Authority (APRA).

While making some key concessions in response to industry feedback, APRA made clear there needs to be limits.

The regulator said that while it broadly supported points made by the industry, it nonetheless proposed a targeted restriction on assets backing longevity products.

“APRA is proposing to apply an additional capital charge for holdings of alternative (unrated) assets and privately rated assets that exceed a specified limit,” it said.

“This targeted restriction aims to balance the benefit industry obtains from having access to a wide range of investments to match long-duration liabilities against the additional risks certain asset types may present to longevity product policyholders.”

Dealing with the feedback it had received from its industry consultation, APRA said the key matters raised in submissions were:

• concerns that certain components of the proposed changes to the illiquidity premium, such as the benchmark, adjustment for risk and cap, may lack flexibility and limit the intended benefits of the proposed changes
• suggestions to expand the scope of products eligible for the illiquidity premium to enhance its impact
• recommendations that the risk controls should be proportionate to the benefits of the proposed changes, noting that overly prescriptive requirements, particularly for cashflow matching, may not suit current market conditions and could be refined to better support practical implementation.

“In response to industry feedback, APRA is proposing a more principles-based approach with updated settings and risk controls to support a risk-sensitive illiquidity premium that is more tailored to a life insurer’s risk profile.

“Appointed Actuary attestations and stress testing are proposed as key risk controls within broader governance processes, ensuring the adoption of the illiquidity premium is appropriate and consistent with prudent risk management practices.

“Overall, the proposed changes aim to improve capital sensitivity to underlying risks and enhance alignment with comparable peer jurisdictions,” it said.

“To support sound investment practices, APRA also proposes limiting capital concessions where cashflow matching assets are alternative (unrated) or privately rated. This seeks to balance investment flexibility for industry to match long-duration liabilities with the need to safeguard policyholders from the additional risks (particularly valuation and credit risks) associated with these asset types.”

APRA’s approach was welcomed by Challenger Limited with managing director, Nick Hamilton claiming the changes “represent a significant improvement to Australia’s current prudential framework”.

“We strongly support APRA’s reforms, which will significantly improve Challenger’s financial resilience and promote growth of the retirement income market.

“These changes will have a number of benefits for Challenger, including lowering the levels of required capital and materially reducing the procyclicality of the capital position during times of market stress,” Hamilton said.