House of Representatives

Explanatory Memorandum

(Circulated by the authority of the Minister for Revenue and Assistant Treasurer, the Hon Peter Dutton MP)

Chapter 1 Discretionary Mutual Funds

Outline of chapter

1.1 Items in Schedule 1 of this Bill amend FSCODA to allow APRA to collect information from DMFs on the role they play in the Australian risk management market and to determine to what extent these entities pose a prudential risk.

1.2 The information will be used to review within 3 years whether it is appropriate to prudentially regulate these entities.

1.3 To complement the information collection under the amendments in Schedule 1 of this Bill, information will also be collected under proposed amendments to the Corporations Regulations from AFSL holders and authorised representatives that use DMF products.

1.4 Consumer protection measures currently applying to retail clients of DMFs will be extended via the Corporations Regulations to DMFs' wholesale clients. Context of amendments

1.5 DMFs offer 'discretionary cover', that is, an insurance-like product that often involves a contractual obligation on the DMF to consider a claim when a risk eventuates, but provides the DMF with a discretion whether it will pay the claim.

1.6 DMFs provide a means of risk management that is an alternative to insurance. DMFs sometimes meet risks for which insurance may not be available or affordable.

1.7 DMFs may be established as a corporation limited by guarantee or trust fund. They are subject to the broader regulatory requirements contained in legislation and under the common law. For example, corporations limited by guarantee are regulated by the Corporations Act as a corporation and trusts are subject to trust laws. Some may also be associations incorporated and regulated under relevant state or territory legislation.

1.8 Following a recommendation by the HIH Royal Commissioner that the Insurance Act be amended to extend prudential regulation to all discretionary insurance-like products, to the extent possible within constitutional limits, the Government commissioned the Potts review in 2004.

1.9 The Potts review found that there was no comprehensive industry or government information available on DMFs. However, from the limited information that was available, it estimated that DMFs only account for approximately 0.5 per cent of the general insurance market.

1.10 Since the Potts review there have been structural and cyclical changes to the Australian general insurance market that have altered the impetus for regulation. These include: tort law reforms, a softening of the insurance market and a fuller understanding of the impact of the Financial Services Reform Act 2001 .

1.11 As a result of these changes, and after further consultation with industry, the Government announced on 3 May 2007 that DMFs will not be subject to prudential regulation at this time. Instead, they will be monitored and information on their role in the Australian general risk market will be collected from DMFs and AFSL holders and authorised representatives who deal in DMF products.

1.12 Once sufficient information has been collected and within three years of the commencement of Schedule 1 of this Bill, a review will be conducted to determine whether it is appropriate to prudentially regulate DMFs.

1.13 In the meantime, the consumer protection provisions that apply to DMFs in dealing with their wholesale and retail clients will be strengthened through an amendment to the Corporations Regulations. This will provide consumers with sufficient information about the risks and benefits of DMFs to make informed decisions about the products they are purchasing.

Summary of new law; comparison of key features of new law and current law

Detailed explanation of new law

1.14 Schedule 1 amends the object of FSCODA to enable APRA to collect information on DMFs.[ Schedule 1, items 1 and 2 ]

1.15 The object provides that APRA can collect information both to assist in the prudential regulation of bodies in the financial sector and to assist in the prudential monitoring of bodies in the financial sector. [ Schedule 1, items 1 and 2 ]

1.16 To achieve this expanded object, FSCODA authorises APRA to determine the reporting standards for registered corporations under the Act and other bodies that it regulates or monitors. This will now include DMFs. [ Schedule 1, items 3 and 4 ]

1.17 This will allow APRA to develop reporting standards to collect quantitative and qualitative information from DMFs. The information that can be collected under the Act from DMFs can include any information that APRA believes may assist it in determining whether it would be appropriate to prudentially regulate DMFs.

1.18 APRA will also have the power to collect information on the role DMFs play in Australia's risk management market and the class of business individual DMFs write (for example, public liability).

1.19 To meet the definition of DMF in the Act, DMFs must satisfy all of the following conditions:

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It must be a fund for making payments to contributors on the happening of an event, where there is uncertainty as to whether, or when, the event will happen.

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Two or more persons must contribute to the fund out of which payments may be made in respect of liabilities, losses, damages or expenses of the contributors.

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The fund must be governed by rules under which any such payment for the benefit of a contributor is subject to a discretion of a person or body.

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A contributor cannot have a right in law or equity to a payment from the fund. However, a contributor will have a right in law to have their claim considered by the fund.[ Schedule 1, items 3 and 4 ]

1.20 In this definition, it is intended that the phrase 'on happening of a specified event, where there is uncertainty as to whether, or when, the event will happen' will be interpreted to have the same meaning as this phrase has for the purposes of insurance contracts. [ Schedule 1, item 4, subsection 5(5 )]

1.21 The entities to be captured by the definition provide risk cover on a discretionary basis to a group of individuals, companies or government entities.[ Schedule 1, items 3 and 4 ]

1.22 DMFs structure in a range of ways but common features include:

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Each member of the group makes contributions to a common fund, which is used to finance the payment of liabilities of members with respect to specified risks (at least up to a certain loss level);

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In return for the payment of contributions, members have a legal right to submit a claim for indemnity and have that claim considered by the relevant entity. However, in each case, the relevant entity may approve the claim at its discretion and use the pool of funds from the membership subscription to pay part or all of the claim.

•

The entity may take out insurance to cover:

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any part of a contributor's claims in excess of the fund retained by the entity; or

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to cover the situation where multiple claims exhaust the fund; or

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to cover a contributor's claim, with the fund having a discretion to cover any excess part of the claim not met by insurance.

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In some funds, the entity may also place a call on its members to contribute additional funds to the pool, if the pool is exhausted.

1.23 These entities may operate by means of a public company limited by guarantee or may be established under a discretionary trust. However, the definition of a DMF is not to be taken as being limited to these legal structures. [ Schedule 1, items 3 and 4 ]

1.24 It is not intended to capture funds that are not financial services business. For example, it is not intended that a family agreeing to pool money to pay for the replacement of a roof after a cyclone be captured under the definition of DMF.

1.25 The definition of DMFs is not intended to capture state insurance arrangements; for example, a DMF set up under statute by the state law society to provide its members with professional indemnity cover. State insurance is to be given the meaning it has under the Constitution. [ Schedule 1, item 5 ]

1.26 APRA may determine the reporting standards for and collect reporting documents from the DMFs caught under the definition under section 13 of FSCODA.

1.27 These reporting standards are legislative instruments for the purposes of the Legislative Instruments Act 2003 .

1.28 DMFs that do not meet the reporting requirements outlined in section 13 of the Act may be subject to the penalties contained in sections 13, 14 and Part 3, Division 3 of the Act. For example, under section 13 a financial entity that fails to comply with a requirement to provide APRA with a reporting document within a particular timeframe may be liable to a maximum fine of 50 penalty units. Similarly, under section 14 of the Act, a principal executive officer of a financial sector entity that fails to notify the governing body of the entity in writing that is has not complied with the reporting requirement outlined above may be liable to a maximum fine of 50 penalty units.

1.29 Part 3 Division 3 outlines administrative penalties that may apply in lieu of prosecution for certain offences, including a failure to comply with the reporting requirements outlined above.

1.30 Schedule 1 provides for regulations to be made deeming entities that do not satisfy the DMF definition to be DMFs for the purposes of the Act and to exempt entities that meet the DMF definition from being DMFs for the purposes of the Act. [ Schedule 1, item 4 ]

1.31 This regulation-making power is necessary because at this time there is only a limited understanding of the various ways in which DMFs may be structured. In order to determine whether prudential regulation of DMFs is warranted a comprehensive collection of information on the range of existing DMFs is necessary.

Application and transitional provisions

1.32 The amendments will commence on Royal Assent. [ Clause 2 ]

1.33 However, the first collection of information will not occur until APRA has developed, in consultation with DMFs, its reporting standards. Subject to consultation with DMFs, it is anticipated that DMFs will commence providing information from a period beginning 1 January 2008.

1.34 A 1 January 2008 commencement date for the reporting standards will allow DMFs to put the systems in place to provide the information to APRA.

Consequential amendments

1.35 There will be an amendment to the definition section, section 31 of the Act, to include DMF as a defined term in the Act. [ Schedule 1, item 6 ]