Capital AdequacyTest 1 – Quantum of assets test

Aims to ensure that the fund holds sufficient assets so that, after 12 months of adverse experience, it would have more assets that

its (then) prudent liabilities.

Stress Test

Represents the amount by which a fund’s capital could deplete over 12 months under a 2nd percentile stressed scenario. Four elements:• Stressed net margin estimate;• Stressed investment income estimate;• Stressed other income estimate; and• Tax.

The insurer needs to use its own method, assumptions and data in order to:• Determine the appropriate percentile to stress the three

elements to give a 2nd percentile overall;• Determine the size of each of the stresses at that percentile.

Stress Test

Stress test amount calculated based on distribution of:• Net margin, which in turn is based on:

o Expected premium $, with rate increase capped at a level slightly above recent insurer-specific benefit increase (yet to be defined); and

o Stressed net margin %;• Stressed investment income $; and • Stressed other income $.

Correlation between these three classes needs to be considered.

Stress Test - Issues

1. Method• Probabilistic or stochastic?• Actuarial black box?

2. Data• What is a 1 in 50 bad year?• At individual component level, what is a 1 in (say) 20 bad year?• Stressed net margin - is past data suitable? If so, for how long?• Stressed investment income

o Allows for market risk, credit risk and balance sheet risk (i.e. incorrect value)

o Where is the data for these risks?• How is the stress determined?

Stress Test - Issues

3. Communication• Board of insurer needs to ensure that each element of the

Standards is properly calculated.• How do they ensure the stress test is “properly calculated”?• How does the AA engage with Board and management?

Stress Test - Issues

FY1990

FY1991

FY1992

FY1993

FY1994

FY1995

FY1996

FY1997

FY1998

FY1999

FY2000

FY2001

FY2002

FY2003

FY2004

FY2005

FY2006

FY2007

FY2008

FY2009

FY2010

FY2011

FY2012

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

PHI Industry performance as % premium

Net margin Inv margin profit margin

Stress Test - Issues1 in percentile Net margin Inv margin profit margin

Last 22 years 50.00% 2 50.00% 1.3% 3.9% 4.6%85.10% 7 14.90% -4.6% 2.5% -0.3%95.00% 20 5.00% -6.5% 0.5% -1.8%98.00% 50 2.00% -7.2% 0.1% -2.1%99.00% 100 1.00% -7.4% 0.0% -2.2%99.50% 200 0.50% -7.6% 0.0% -2.2%99.75% 400 0.25% -7.6% 0.0% -2.2%

1 in percentile Net margin Inv margin profit marginLast 10 years 50.00% 2 50.00% 4.3% 3.4% 6.7%

85.10% 7 14.90% 2.1% 0.6% 2.8%95.00% 20 5.00% 0.8% 0.2% 1.0%98.00% 50 2.00% 0.3% 0.0% 0.2%99.00% 100 1.00% 0.2% 0.0% -0.1%99.50% 200 0.50% 0.1% 0.0% -0.3%99.75% 400 0.25% 0.1% -0.1% -0.4%

1 in percentile Net margin Inv margin profit marginLast 5 years 50.00% 2 50.00% 4.3% 2.7% 7.6%

85.10% 7 14.90% 3.8% 0.2% 4.0%95.00% 20 5.00% 3.4% 0.0% 3.4%98.00% 50 2.00% 3.2% 0.0% 3.2%99.00% 100 1.00% 3.2% 0.0% 3.2%99.50% 200 0.50% 3.2% -0.1% 3.1%99.75% 400 0.25% 3.2% -0.1% 3.1%

Insights – 2 July 2013 – PHI Capital Standards

Part 2: Other Capital Adequacy Items, &Capital Management Policy

Other Cap Ad components (“Quantum”)

Operational Risk: - $1m + ½%: - Growth component removed- Includes ½% of non-insurance-business HRB revenue

Prudent Liabilities: - Pragmatic uplift from insurers 75% PoA accounting estimates- Other liabilities (eg loyalty bonus) need 98% PoA estimates- Pragmatic use of commencing liabilities

Supervisory Adjustment: - As always, PHIAC have room to intervene, but subject to AAT

Subordinated Debt: - Tougher rules: “genuinely loss absorbing”- but can keep previously approved S.D.

Other Cap Ad components (“Concentration”)

“Capital Adequacy Maximum Default Loss Amount” (‘CAMDLA’?): - single maximum counterparty exposure- excluding Fed/State/Territory government, ADI- net of recoveries

CAMDLA must exceed: (Prudent liabilities) + (Supervisory adjustment if any)

Practical issues?: - Look through = a continuous responsibility- Property: related parties, subdivisions, strata titles

Capital Management PolicyHas been foreshadowed and informally “required” for years

Significantly more formal requirements: Contents and Process

Contents:- Stated risk appetite- Capital targets- Triggers for action; and options for action- Link to pricing policy and implications for prices (i.e. customers)- Investment policy- Liquidity management

Process: - Authority (Board approved)- Timing (at least every 2 years- Method (probabilistic)

Issues?Cap Ad Quantum:

• Pragmatic Prudent liabilities for Cap Ad – are the value factors too simplistic? Does the pragmatism act unfairly in some circumstances?

• Operational risk on non-health-insurance HRB – does this matter?• Are the subordinated debt rules too tough?

Cap Ad Concentration:• Look through = a continuous responsibility; will this limit reasonable actions?• Strata title and similar – insurer’s obligation to self-assess whether parties are related

Cap Ad Overall: does Cap Ad produce too low or too high a requirement?

Capital Management Policy:• Significantly more responsibility on the Board – Cap Ad seems lower, so CMP will drive

capital from first principles?• What are the headline risks that capital must protect against?

• Failure to meet policyholder promises? – previously this has been negligible• Failure to meet regulatory obligations?• Failure to meet shareholder goals?

• Are “probabilistic” methods sufficient alone? Are additional analyses necessary?• Greater sophistication required from most insurer’s plans

Insights – 2 July 2013 – PHI Capital Standards

Part 3: Solvency requirements

Solvency requirementOverview

16

Accounting liability

Solvency

Prudent Liability

Cash managementamount

60% of cash managementamount

3 month Stress test

Stressedlossesamount

Solvency MaximumDefault

Loss Amount

All assets Solvencyqualifyingassets

Band 1 assets

Band 1 assets

Solvency non-qualifying

assets

Band 2 assets

Solve

ncy

Asse

ts

Solve

ncy

Asse

ts

Solve

ncy

Asse

ts

Solve

ncy

Asse

ts

Current standards Proposed standards 2012 Proposed 2013 standards Liquidity test

Proposed 2013 standards Concentration of liquid assets

test

Excess Assets Excess

Assets

Excessqualifying assets

Excess band 1 assets

Excessassets

Maximum loss on the largest asset counterparty group (Band 1 assets)

% of future contributions

% of future contributions

Equities @ 50% value

Cash and Aus gov. bonds

Solvency requirementComparison to previous capital standards

17

Accounting liability

Solvency

Prudent Liability

Cash managementamount

60% of cash managementamount

3 month Stress test

Stressedlossesamount

Solvency MaximumDefault

Loss Amount

All assets Solvencyqualifyingassets

Band 1 assets

Band 1 assets

Solvency non-qualifying

assets

Band 2 assets

Solve

ncy

Asse

ts

Solve

ncy

Asse

ts

Solve

ncy

Asse

ts

Solve

ncy

Asse

ts

Current standards Proposed standards 2012 Proposed 2013 standards Liquidity test

Proposed 2013 standards Concentration of liquid assets

test

Excess Assets Excess

Assets

Excessqualifying assets

Excess band 1 assets

Excessassets

Solvency requirementQualifying assets

18

Introduction► Not all assets are counted for solvency purposes► Qualifying assets are divided into 2 bands

Accounting liability

Solvency requirement

Prudent Liability

Cash managementamount

60% of cash managementamount

3 month Stress test

Stressedlosses

amountSolvency MaximumDefault

Loss Amount

All assets Solvencyqualifying

assets

Band 1 assets

Band 1 assets

Solvency non-qualifying

assets

Band 2 assets

Solve

ncy

requ

irem

ent

Asse

ts

Solve

ncy

requ

ireme

nt

Asse

ts

Solve

ncy

requ

irem

ent

Asse

ts

Solve

ncy

requ

irem

ent

Asse

tsCurrent standards Proposed standards 2012 Proposed 2013 standards

Liquidity testProposed 2013 standards

Concentration of liquid assets test

Solvency requirementQualifying assets

19

Band 1► 100% of the value counted► Definition: “highest liquidity and are

expected to remain so over any reasonably foreseeable future stressed circumstances”

► Prescribed asset types• Cash and cash equivalents

(AASB definitions)• Assets with Australian

government counterparty (excluding risk equalisation receivable)

Band 2► 50% of the value counted► Securities listed on the ASX or a principal

foreign exchange► Board must be satisfied that these assets

can be readily converted to cash under highly stressed market scenarios

No allowance for other assets not in the prescribed list, even if it satisfies the definition.

Eg highly liquid foreign government bonds

No guidance on a reasonable methodology in which the Board should adopt its opinion

• AASB107 Para 7• Cash equivalents are held for the purpose of meeting short-term

cash commitments rather than for investment or other purposes. For an investment to qualify as a cash equivalent it must be readily convertible to a known amount of cash and be subject to an insignificant risk of changes in value. Therefore, an investment normally qualifies as a cash equivalent only when it has a short maturity of, say, three months or less from the date of acquisition. Equity investments are excluded from cash equivalents unless they are, in substance, cash equivalents, for example in the case of preferred shares acquired within a short period of their maturity and with a specified redemption date.

Solvency requirementQualifying assets

Solvency requirementCash management amount

21

► 8% of the fund’s Health Business Revenue Estimate (HBR) for the next 12 months as per the Cap. Ad. Stress Test

► PHIAC’s view is that liquidity requirements are related to contribution income.

► Does not give credit to high profit margins

Accounting liability

Solvency requirement

Prudent Liability

Cash managementamount

60% of cash managementamount

3 month Stress test

Stressedlosses

amountSolvency MaximumDefault

Loss Amount

All assets Solvencyqualifying

assets

Band 1 assets

Band 1 assets

Solvency non-qualifying

assets

Band 2 assets

Solve

ncy

requ

ireme

nt

Asse

ts

Solve

ncy

requ

ireme

nt

Asse

ts

Solve

ncy

requ

ireme

nt

Asse

ts

Solve

ncy

requ

ireme

nt

Asse

ts

Current standards Proposed standards 2012 Proposed 2013 standards Liquidity test

Proposed 2013 standards Concentration of liquid assets test

Solvency requirementStressed losses amount

22

► HBR x min [62% x SEUs-0.22, 13%]

► Health Business Revenue Estimate (HBR)

0%1%2%3%4%5%6%7%8%9%

10%11%12%13%14%

1 100 200 300 400 500 600 700 800 900 1,000

Char

ge o

n He

alth

Busin

ess

Reve

nue

Estim

ate

(%)

Fund SEUs ('000)

Solvency Stressed losses amount

Solvency Stressed losses amount

Accounting liability

Solvency requirement

Prudent Liability

Cash managementamount

60% of cash managementamount

3 month Stress test

Stressedlosses

amountSolvency MaximumDefault

Loss Amount

All assets Solvencyqualifying

assets

Band 1 assets

Band 1 assets

Solvency non-qualifying

assets

Band 2 assets

Solve

ncy

requ

ireme

nt

Asse

ts

Solve

ncy

requ

ireme

nt

Asse

ts

Solve

ncy

requ

ireme

nt

Asse

ts

Solve

ncy

requ

ireme

nt

Asse

ts

Current standards Proposed standards 2012 Proposed 2013 standards Liquidity test

Proposed 2013 standards Concentration of liquid assets test

Solvency requirementSolvency Maximum Default Loss Amount and Solvency Supervisory Adjustment amount

23

Solvency Maximum Default Loss Amount► Same as the Cap. Ad. Equivalent but only

applied to Band 1 assets

Solvency Supervisory Adjustment amount► As per Cap. Ad – if PHIAC believes any of

the other Solvency components are inadequate

► Not shown in the graphAccounting

liability

Solvency requirement

Prudent Liability

Cash managementamount

60% of cash managementamount

3 month Stress test

Stressedlosses

amountSolvency MaximumDefault

Loss Amount

All assets Solvencyqualifying

assets

Band 1 assets

Band 1 assets

Solvency non-qualifying

assets

Band 2 assets

Solve

ncy

requ

ireme

nt

Asse

ts

Solve

ncy

requ

ireme

nt

Asse

ts

Solve

ncy

requ

ireme

nt

Asse

ts

Solve

ncy

requ

ireme

nt

Asse

ts

Current standards Proposed standards 2012 Proposed 2013 standards Liquidity test

Proposed 2013 standards Concentration of liquid assets test

• Stressed losses amount – revenue basis• Term deposit treatment– Liquidity, breakability, duration to maturity, AASB

definitions clarity• Cash management amount – revenue basis

versus claims + expenses

Solvency requirementSolvency Maximum Default Loss Amount and Solvency Supervisory Adjustment amount