Prudential Regulation Authority Research Articles

Private health insurance incentives and passive adverse selection: is Lifetime Health Cover responsible for the excess ageing of Australia's hospital cover risk pool?

ObjectiveLifetime Health Cover (LHC) was introduced in mid-2000 to increase participation in private health insurance that includes hospital cover (PHI-HC) and improve the risk profile of PHI-HC participants. It initially achieved both objectives, but since 2001 the PHI-HC population has aged faster than the general population. The aim of this study was to determine if the excess ageing of the PHI-HC risk pool has been due to passive age-based adverse selection, an inherent risk of LHC. This study has potential implications for the retention of LHC.MethodsA descriptive population-level analysis of publicly available administrative datasets was performed. Data relating to PHI-HC were obtained from the Australian Prudential Regulatory Authority. National population data were obtained from the Australian Bureau of Statistics. Trends in demography, PHI-HC participation rates and LHC loading payments were analysed.ResultsBy 2021, age-based adverse selection had returned to the pre-LHC level. Based on the available data, this was due to passive age-based adverse selection not active age-based adverse selection. Specifically, it reflected the combination of an avoidable unintended consequence of the introduction of LHC (the over-representation, in 2001, of individuals aged 45-59) and one of LHC's intended effects (incentivisation of insured individuals to retain PHI-HC).ConclusionsThis study supports the retention of LHC. Nonetheless, it highlights the risk of passive age-based adverse selection created by incentivising insured individuals to retain PHI-HC in the presence of distortions in the age distribution of the PHI-HC risk pool. Early targeted interventions are required when such distortions arise.

Consideration of the proxy modelling validation framework

Abstract Solvency II requires that firms with Internal Models derive the Solvency Capital Requirement directly from the probability distribution forecast generated by the Internal Model. A number of UK insurance undertakings do this via an aggregation model consisting of proxy models and a copula. Since 2016 there have been a number of industry surveys on the application of these models, with the 2019 Prudential Regulation Authority (“PRA”) led industry wide thematic review identifying a number of areas of enhancement. This concluded that there was currently no uniform best practice. While there have been many competing priorities for insurers since 2019, the Working Party expects that firms will have either already made changes to their proxy modelling approach in light of the PRA survey, or will have plans to do so in the coming years. This paper takes the PRA feedback into account and explores potential approaches to calibration and validation, taking into consideration the different heavy models used within the industry and relative materiality of business lines.

Review of the senior managers & certification regime

Following the 2022 Edinburgh Reforms, in which the Chancellor of the Exchequer announced a set of reforms designed to drive growth and competitiveness in the financial services sector, both HM Treasury and the Financial Conduct Authority (FCA) with the Prudential Regulation Authority initiated consultations to review the Senior Manager and Certification Regime (SM&CR). The aim of the review was to understand stakeholders’ views on how well the SM&CR is functioning and to identify ways to improve the regime to help it work better for firms and regulators. The SM&CR is seen as an essential tool to strengthen the financial services market by ensuring that financial services professionals are individually accountable to their employers and to the regulators. This article examines how the SM&CR has been operating to date and critically analyses whether it is achieving its original aims. The impact of the SM&CR on the international competitiveness of the UK financial services sector is considered, with comparisons drawn with the United States. Ultimately, this article recommends a greater use by the FCA of its enforcement powers to sanction senior managers, to ensure the international competitiveness of the UK financial services sector and to deter financial crime.

ANALYSIS OF ROBUST CHAIN LADDER METHOD IN ESTIMATING AUSTRALIAN MOTOR INSURANCE RESERVES WITH OUTLYING DATASET

Reserves are one of the most crucial components for an insurance company to make sure it has enough money to pay off all the incurred claims. The presence of outliers in the incurred claims data harbors risk on inaccurately predicting reserves to cover claim amounts, usually achieved by the standard chain ladder reserving method. To remedy the effect of the outliers, the robust chain ladder reserving method is used by setting the median value to predict estimated reserve. On this research, we utilized both methods on various datasets. The purpose of this paper is to determine the best method that can be utilized by insurance company in various scenario to obtain the most optimized reserved estimate that can minimize the risk of being unable to pay the insurance claim or even the risk of over allocating reserves that could pose profitability issue. The primary data used are the Australian domestic motor insurance claims from 2012 to 2017, obtained from Australian Prudential Regulation Authority (APRA). The dataset is then manipulated to have outliers. After calculating the estimation, the result is compared to assess the strength of the methods using Mean Squared Error (MSE) and Root Mean Squared Error (RMSE) calculation. In conclusion, we found that the robust chain ladder reserving method works better in an outlying dataset. We also identify cases in which robust chain ladder are not appropriately used.

Designing Stress Tests for UK Fast-Growing Firms and Fintech

This paper captures advances in prudential regulation and supervision for challenger banks and fintech in the UK. It presents a critical analysis of the prudential supervisory approaches towards fintech. The focus is placed on fast-growing firms (FGFs), building on the review performed by the Prudential Regulation Authority (PRA) of the Bank of England (BoE) in 2019. Specifically, it comprises a critical examination of the underlying regulatory framework in relation to the robustness of stress testing practices, as part of the review of FGF risk management practices and the weakness identified in the Internal Capital Adequacy Assessment Process (ICAAP). The economic analysis of law comprises the underlying methodology, using economic theory to analyse regulation and its effectiveness regarding fintech regulation and supervision. Recommendations for enhancements towards supervisory practices about the prudential governance and management of FGFs and fintech are included, with advances to the underlying regulatory framework in the UK. Overall, this critical legal research examines the supervisory practices of FGFs and fintech in the UK, under the lens of prudential regulation and risk management approaches, focusing on the design, development and implementation of the stress testing tool and scenario practices.

Addressing the challenges of post-pandemic debt management in the consumer and SME sectors: a proposal for the roles of UK financial regulators

Regulatory actions for short-term debt-relief during the Covid-19 pandemic are facilitating a significant level of indebtedness. We argue that regulators, in leaving the banking sector to manage small business and consumer debtors in ‘tailored arrangements’, risk allowing financial welfare goals to be unmet. Financial welfare goals are important to the Financial Conduct Authority’s (FCA) consumer protection objective and give substantive meaning to the long-term financial stability objective of the Prudential Regulation Authority (PRA). Although the struggles with debt on the part of small and medium-sized businesses and households are not capable of complete resolution by financial regulators, who are constrained by their statutory mandates, we argue that the PRA and FCA should establish a coordinated supervisory framework of ‘tailored supervision’ for banks’ ‘tailored arrangements’ with their debtors. This proposal allows both regulators to address to an extent the needs of unsophisticated post-pandemic debtors and meet their objectives in a joined-up and holistic manner.

Consequences of the Australian Prudential Regulatory Authority’s Investment Performance Tests

The Australian Prudential Regulatory Authority (APRA) has introduced for MySuper products a publicly available comparison of investment performance over three-year rolling periods and will be introducing a similar longer-term comparison under the Your Future Your Super Performance Test. The investment performance will be compared to a reference portfolio. This paper considers the effect of holding illiquid assets and “active” investment management as part of a superannuation fund portfolio and concludes the APRA tests may have undesirable consequences for superannuation fund members.

How executive remuneration responds to guidance: evidence from the Australian banking industry

AbstractThis study investigates whether executive remuneration responds to regulatory guidance. Using an exogenous shock in the form of a regulatory guideline issued by the Australian Prudential Regulation Authority to the Australian banking industry, we analyse whether remuneration is more aligned to prudent risk‐taking since the guideline was published. We find that remuneration to both chief executive officers and the top five highest paid executives was adjusted to be more consistent with the guideline from its first year of operation. These findings are robust to the introduction of the Two Strikes Rule as an alternative explanation.

An Analysis of the Rationale & Risks for the Australian Your Future Your Super Performance Test

The Your Future Your Super reforms introduced in June 2021 include an investment performance test (YFYSPT) for MySuper products initially, but the Australian Prudential Regulatory Authority (APRA) intends to extend the YFYSPT to other superannuation products from 2022. This paper assesses the YFYSPT from the perspectives of achieving market efficiency, providing information that members of superannuation products can use to make informed decisions, and better aligning the member-agent interest. The paper also analyses the sources of risk that might cause MySuper products to fail the YFYSPT. The paper concludes that the YFYSPT is likely to improve market efficiency and reduce the misalignment of members’ and investment managers’ interests but fails to provide a meaningful basis for members to make informed decisions. There are also technical issues in the formulation of the YFYSPT. The major risk of failing the YFYSPT arises from the use of active investment management that does not produce returns net of investment and administration fees and taxes in excess of the YFYSPT indices.

Impact of the COVID-19 Pandemic on Manual Therapy Service Utilization within the Australian Private Healthcare Setting

The COVID-19 pandemic has impacted a wide range of health services. This study aimed to quantify the impact of the COVID-19 pandemic on manual therapy service utilization within the Australian private healthcare setting during the first half of 2020. Quarterly data regarding the number and total cost of services provided were extracted for each manual therapy profession (i.e., chiropractic, osteopathy, and physiotherapy) for the period January 2015 to June 2020 from the Australian Prudential Regulation Authority. Time series forecasting methods were used to estimate absolute and relative differences between the forecasted and observed values of service utilization. An estimated 1.3 million (13.2%) fewer manual therapy services, with a total cost of AUD 84 million, were provided within the Australian private healthcare setting during the first half of 2020. Reduction in service utilization was considerably larger in the second quarter (21.7%) than in the first quarter (5.7%), and was larger in physiotherapy (20.6%) and osteopathy (12.7%) than in chiropractic (5.2%). The impact varied across states and territories, with the largest reductions in service utilization observed in New South Wales (17.5%), Australian Capital Territory (16.3%), and Victoria (16.2%). The COVID-19 pandemic has had a profound impact on manual therapy service utilization in Australia. The magnitude of the decline in service utilization varied considerably across professions and locations. The long-term consequences of this decline in manual therapy utilization remain to be determined.

Service utilisation trends in the manual therapy professions within the Australian private healthcare setting between 2008 and 2017

BackgroundBetter understanding of the dynamics and temporal changes in manual therapy service utilisation may assist with healthcare planning and resource allocation. The objectives of this study were to quantify, describe, and compare service utilisation trends in the manual therapy professions within the Australian private healthcare setting between 2008 and 2017.MethodsData regarding the number of services, total cost, and benefits paid were extracted for each manual therapy profession (i.e. chiropractic, osteopathy, and physiotherapy) for the period 2008–2017 from the Australian Prudential Regulation Authority. The number of registered providers for each profession were obtained from the Australian Health Practitioner Regulation Agency. Descriptive statistics were produced for two time periods (i.e. 2008–2012 and 2013–2017) for each manual therapy profession. Annual percentage change during each time period was estimated by fitting Poisson regression models. Test for the equality of regression coefficients was used to compare the trends in the two time periods within each profession, and to compare the trends across professions within a time period.ResultsA cumulative total of 198.6 million manual therapy services with a total cost of $12.8 billion was provided within the Australian private healthcare setting between 2008 and 2017. Although service utilisation and total cost increased throughout the ten-year period, the annual growth was significantly lower during 2013–2017 than 2008–2012. Whereas osteopathy and physiotherapy experienced significant annual growth in the number of services and total cost during 2013–2017, negative growth in the number of services was observed for chiropractic during the same period. The annual number of services per provider declined significantly for chiropractic and physiotherapy between 2013 and 2017.ConclusionService provision under private health insurance general treatment cover constitute a major source of revenue for manual therapy professions in Australia. Although manual therapy service utilisation increased throughout the ten-year period from 2008 to 2017, the annual growth declined. There were diverging trends across the three professions, including significantly greater decline in annual growth for chiropractic than for osteopathy and physiotherapy.

Switching between superannuation funds: Does performance and marketing matter?

This study examines the roles of fund performance and marketing in superannuation members' fund switching activity in Australia. Using member-nominated transfers from a unique data set of Australian Prudential Regulation Authority (APRA)-regulated superannuation funds from 2005 to 2014, our results indicate that members who switched funds do not chase after superior short-term returns but they do punish bad performers by withdrawing investments. We find a consistent positive relation between marketing effort and investor choice for retail funds, which engage in extensive marketing. However, marketing does not appear to be an effective strategy for industry-based funds to attract investments.

Evaluation of the UK Islamic Banking System, Challenges and Prospects

Under the UK financial law, Islamic banks are treated in the same way as conventional banks-there is no special Islamic banking law, nor is there any provision under the current banking law system for Islamic banks. The Financial Services Authority (FSA), the Financial Conduct Authority (FCA) and the Prudential Regulatory Authority (PRA) regulate and supervise all financial institutions, and this includes Islamic banks. However, the only official document to mention Islamic banks is a paper issued by Her Majesty’s Treasury, which simply explains Islamic banking rather than setting out any rules or regulations. The UK banking system’s policy is to not favoritise any specific type of financial institution; all institutions are treated equally, without giving Islamic banks a special treatment.The UK government has tried to facilitate and assist Islamic banks with developing and conducting their activities effectively. many obstacles that previously faced Islamic banks in the country have either been removed or at least reduced to some extent. These efforts have been made to open the gate for Islamic banks to enter the UK banking market and develop their business there. For example, as described in this paper, some changes have been made concerning tax regulation and legislation to help facilitate Islamic banking transactions. In addition, the Islamic Bank of Britain’s definition of ‘deposit’ has been modified to become more acceptable. Generally speaking, the Islamic banking industry in the UK is managed and organised very well, regardless of there being no special Islamic banking law. However, some issues are still existing and faced by Islamic banks in the UK, such as lack of Islamic banking law, shortage of experts, and lack of transparency. Thus, this paper evaluated and criticised the Islamic banking system of the UK and attempted to find out solutions for all these issues. Keywords: the United Kingdom, Islamic Banks and Challenges DOI: 10.7176/PPAR/10-8-04 Publication date: August 31 st 2020

Has the Australian Prudential Regulation Authority Done Enough to Meet Its Legislated Objectives and Prepare Australia for the Next Financial Crisis?

This article examines APRA’s performance against its legislated objectives and the policy rationales and legal theories underlying the supervision of prudential regulation and promotion of financial system stability. The article will investigate the prudential framework in place and actions taken by APRA in the period beginning January 2014 to the end of June 2018, focusing on APRA’s oversight of residential property lending standards because the quality of these loans will be the single largest determinant of the future health of the Australian financial system. The current study’s findings and broader evidence suggest that APRA’s responses to ongoing lax and risky home lending standards were ad hoc, conservative, and reactive.

Text mining letters from financial regulators to firms they supervise

AbstractOur article uses text mining techniques to examine confidential letters sent from the Bank of England’s Prudential Regulation Authority (PRA) to financial institutions it supervises. These letters are a ‘report card’ written to firms annually, and are the most important, regularly recurring written communication sent from the PRA to firms it supervises. Using two complementary machine learning techniques—random forests and logistic ridge regression—we explore whether the letters vary in substance and style depending on the size and importance of the firm to whom the PRA is writing. We find that letters to high impact firms use more evaluative, judgment-based language, and adopt a more forward-looking perspective. We also examine how PRA letters differ from similarly purposed letters written by its predecessor, the Financial Services Authority. We find evidence that PRA letters are different, with a greater degree of forward-looking language and directiveness, reflecting the shift in supervisory approach that has occurred in the UK following the financial crisis of 2007–09.

Reviewing Pillar 2 regulations: credit concentration risk

PurposeThis paper aims to analyse the recent changes to the Pillar 2 regulatory-prescribed methodologies to classify and calculate credit concentration risk. Focussing on the Prudential Regulation Authority’s (PRA) methodologies, the paper tests the susceptibility to bias of the Herfindahl–Hirscham Index (HHI). The empirical tests serve to assess the assumption that the regulatory classification of exposures within the geographical concentration is subject to potential misuse that would undermine the PRA’s objective of obtaining risk sensitivity and improved banking competition.Design/methodology/approachUsing the credit exposure data from three global banks, the HHI methodology is applied to the portfolio of geographically classified exposures, replicating the regulatory exercise of reporting credit concentration risk under Pillar 2. In doing so, the validity of the aforementioned assumption is tested by simulating the PRA’s Pillar 2 regulatory submission exercise with different scenarios, under which the credit exposures are assigned to different geographical regions.FindingsThe paper empirically shows that changing the geographical mapping of the Eastern European EU member states can result in a substantial reduction of the Pillar 2 credit concentration risk capital add-on. These empirical findings hold only for the banks with large exposures to Eastern Europe and Central Asia. The paper reports no material impact for the well-diversified credit portfolios of global banks.Originality/valueThis paper reviews the PRA-prescribed methodologies and the Pillar 2 regulatory guidance for calculating the capital add-on for the single name, sector and geographical credit concentration risk. In doing so, this paper becomes the first to test the assumptions that the regulatory guidance around the geographical breakdown of credit exposures is subject to potential abuse because of the ambiguity of the regulations.

Australia

This Detailed Assessment of Observance report specifies Base Core Principles (BCP) for effective banking supervision in Australia. An assessment of the effectiveness of banking supervision requires a review of the legal framework, and a detailed examination of the policies and practices of the institution(s) responsible for banking regulation and supervision. In line with the BCP methodology, the assessment focused on banking supervision and regulation in Australia and did not cover the specificities of regulation and supervision of other financial institutions. The assessment has made use of five categories to determine compliance: compliant; largely compliant, materially noncompliant, noncompliant, and non-applicable. The report insists that Australian Prudential Regulation Authority (APRA) should put more focus on assessing the various components of firms’ Internal Capital Adequacy Assessment Process and other firm-wide stress testing practices. A periodic more comprehensive assessment of banks’ risk management and governance frameworks will further enhance APRA’s supervisory approach.

Recalculation of the Solvency II transitional measures on technical provisions

Abstract Solvency II came into force on 1 January 2016 and included a transitional measure on technical provisions (“TMTP”) designed to help smooth in the capital impact of Solvency II over a 16-year period. The working party’s view is that the main intention of the TMTP is to mitigate the impact of the introduction of the risk margin, which significantly increases the technical provisions of firms, relative to their Solvency I Pillar 2 liabilities. The majority of firms who hold a TMTP have now had at least one recalculation approved by the Prudential Regulation Authority (PRA); or are in the process of applying for a recalculation. Despite this large number of approved recalculations, there remains significant uncertainty in the industry around the approach and triggers for recalculation. This paper considers aspects of TMTP recalculation for regulated UK life firms, for example practicalities of the calculation, asset and liability considerations, and communications/announcements. In this paper, we outline the need for pragmatism when considering the approach to recalculation of a measure originally intended to serve as the bridge between two regimes. We call for an allowance for doing what is sensible in a principles-based regime balancing what might be more theoretically correct with what is practical and possible to support effective management of the business.

Regulation Without the State: The Example of Financial Services

There are frequent calls for financial markets to be more actively regulated by state agencies, such as the Financial Conduct Authority or the Prudential Regulation Authority. They reflect neo-classical, market-failure approaches to economics, which suggest that the market does not maximise welfare if certain conditions do not hold and that government action is required to move the market towards the welfare-maximising position. But we cannot know whether government regulatory action will move us away from or towards the welfare-maximising position unless we also make unrealistic assumptions about behaviour in regulatory agencies. The neo-classical, market-failure approach therefore takes us down an intellectual rabbit hole. It is instead possible to think of regulation as part of the set of services provided by the market, rather than something that to be done to the market ex-post. The discovery of regulatory organisations is part of the entrepreneurial market process. Regulatory institutions evolving within the market continue to evolve, despite the attempts by government agencies to regulate markets in very detailed ways. Modern examples would include the International Swaps and Derivatives Association (ISDA), whose record during the financial crisis was faultless. There are disadvantages arising from private regulatory bodies: they can encourage cartelistic behaviour and may prove less effective where the economic activity in question gives rise to widespread social costs beyond market participants. However, we should reject market failure analysis and operate under the assumption that the market can provide regulatory services because they are valued by market participants. Where statutory regulation is used, it should generally be voluntary with products not regulated by the statutory regulator being clearly identified as such.

Climate risk reporting practices by UK insurance companies and pension schemes

Abstract Increasing global concern over the impact of climate change has recently led to public scrutiny over the adequacy of existing risk management practices by insurance companies and pension schemes in dealing with these challenges that potentially impact both individual actuaries and the Institute and Faculty of Actuaries generally. Most recently, the Prudential Regulation Authority has issued further guidance concerning its expectations for the UK insurance industry regarding the development of an approach to disclosure on and management of the financial risks from climate change, while a Parliamentary Committee has demanded public clarification from UK pension scheme trustees regarding their degree of engagement with incorporating climate-related financial risks into their investment decision-making. The aim of this paper is to identify the dominating factors of the current evolvement of UK insurance companies’ and pension schemes’ climate risk disclosure practices. This paper analyses both the nature and extent of changes in the risk reporting practices of these entities that have evolved in order to meet these demands for increased accountability. We first analyse relevant sections of latest annual reports produced by a sample of 15 UK insurance companies and 15 pension schemes. We find only limited alignment of insurance firm and pension scheme annual reports with the 11 specific Task Force on Climate-Related Financial Disclosure’s (TCFD) recommended disclosures. We also examine what key financial risk and/or other organisational characteristics are most closely associated with the degree of alignment with TCFD specified disclosures related to governance, strategy, risk management and performance metrics. We find that incentives facing sample insurance companies to align their climate-related disclosures with TCFD recommendations are related to their management of reputation risk (measured on the basis of size and type of business). Whereas the incentives facing pension schemes are related to the desire to reduce information asymmetry (measured by liability risk) among their stakeholders concerning this issue. Further, consistent with a stakeholder theory explanation, it appears that only a minority of large, publicly listed insurance companies and large local government pension schemes are taking action to report on their actions to mitigate climate risk. We also discuss examples of best practice climate risk reporting. The implications for the actuarial profession in engaging with climate risk are discussed in line with the findings of the study.