House of Representatives

Explanatory Memorandum

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

Chapter 6 Regulation impact statement: Direct Offshore Foreign Insurers

Background

6.1 The issue of the regulation of DMFs and DOFIs arose within the context of the collapse of HIH Insurance Limited. The HIH Royal Commissioner recommended that the Australian Government amend the Insurance Act to extend prudential regulation to all discretionary insurance-like products - to the extent possible within constitutional limits. He also made some comments regarding DOFIs.

6.2 In response to the HIH Royal Commission report, the Government commissioned the Potts review to examine the extent and nature of DMFs and DOFIs operating in Australia and their contribution to overall risk capacity.

6.3 DOFIs are foreign insurers that sell insurance to Australians, either directly or via an insurance agent or broker licensed in Australia under the Corporations Act, without establishing a subsidiary or branch. These foreign insurers are not subject to the provisions of the Insurance Act because they are not considered to be 'carrying on insurance business in Australia' under sections 9 and 10 of the Insurance Act. However, these DOFIs may be subject to prudential and consumer regulation in their home jurisdiction.

6.4 The Potts review recommended that the APRA regulate all DMFs with contingent risk and all DOFIs that did not come from a regime with prudential regulation that APRA considered comparable to the Australian prudential regime. In May 2004, the Government accepted the Potts review recommendations.

6.5 Since then there have been a number of structural and cyclical changes to the Australian general insurance market, including a fuller understanding of the impact of the Financial Services Reform Act 2001 , tort law reforms and a softening of the insurance market, altering the impetus for regulation.

6.6 In December 2005, Treasury released a discussion paper seeking public input on proposals to implement the Potts review recommendations. Treasury received submissions from Australian general insurers, DOFIs, DMFs, captives, reinsurers, brokers and agents, state governments and regulators.

6.7 As a result of these submissions and the release of the Banks Taskforce report Rethinking Regulation : Report of the Taskforce on Reducing Regulatory Burdens on Business on 7 April 2006, the Government is seeking to depart from the Potts review recommendations. This regulation impact statement (RIS) seeks policy approval for that departure.

6.8 The Potts review found that DOFIs accounted for approximately 2.5 per cent of the general insurance market and that their number was growing steadily. DOFIs appeared to often fill market niches, either by way of specialised insurance (such as insuring classic cars) or policies that authorised insurers were not prepared to offer (for example, public liability cover for waterslides and theme parks). However, the Potts review also found that there was a significant amount of property insurance for wholesale clients being written by DOFIs. In recent years there has been an increasing trend for offshore insurers to move into the longer tail classes of insurance, such as professional indemnity and public liability insurance. Anecdotal evidence also indicated that the type of public liability risk being insured overseas was primarily tourism and recreation related cover, for activities such as waterslides and theme parks, horse riding schools and motor racing.

Problem identification

6.9 The HIH Royal Commission report noted that Australian entities may insure risks in Australia with offshore foreign insurers that are not authorised under the Insurance Act. Australian policyholders can purchase such insurance directly or through an Australian agent or broker. The report noted that in some cases it might be unnecessary to regulate insurance written offshore. Much of this business is likely to involve large commercial insurance contracts where a purchaser would normally be considered able to judge for itself the risks involved in the transaction. However, there were suggestions that such arrangements constituted a gap in APRA's current regulatory reach. This could have implications for Australians unaware that they were purchasing an overseas insurance product.

6.10 The Potts review found that the current regulatory treatment of foreign insurers operating in Australia lacked consistency. Foreign insurers were treated in different ways depending on whether they were foreign insurers authorised by APRA operating in Australia; Lloyd's underwriters authorised under special provisions of the Insurance Act; or unauthorised foreign insurers conducting business in Australia directly or through agents or brokers. Foreign insurers not authorised in Australia were domiciled in jurisdictions with different regulatory regimes. This meant that the degree of protection afforded to policyholders with similar insurance risks would vary depending on the country of origin of the insurer they selected.

6.11 At the same time, however, the Potts review was concerned to avoid prohibiting commercial arrangements that have worked satisfactorily to date. It considered that the Government should target its regulation at areas of highest risk, such as foreign insurance companies operating out of low status regulatory jurisdictions with minimal prudential requirements.

6.12 ASIC media releases outlined actions and orders that ASIC obtained against overseas insurers and their local agents within Australia. A number of investigations have followed complaints that foreign insurers were not paying claims, or trading while insolvent. One example related to International Unity Insurance (General) Limited and its Australian agent, International Unity Insurance Pty Ltd, a Solomon Island insurer providing motor vehicle insurance products to Australians.

Objectives

6.13 The policy objective is to ensure that policyholders with similar risks are afforded a similar degree of protection regardless of the origin of their insurer, while ensuring that commercial arrangements that have worked satisfactorily to date are not prohibited. It is also to ensure that no higher standard is imposed on foreign insurers than domestic general insurers.

6.14 As noted above, foreign insurers are treated in different ways. Foreign insurers authorised by APRA and Lloyd's underwriters are regulated through the Insurance Act, administered by APRA. However DOFIs (those foreign insurers conducting business in Australia through brokers and agents and those who market their product directly to Australians through the internet for example) are not required to be prudentially regulated in Australia under the Insurance Act.

6.15 DOFIs, like any other Australian general insurer carrying on a financial services business in Australia are required to hold an AFSL and comply with the conditions of that licence. These conditions are set out in Chapter 7 of the Corporations Act.

6.16 DOFIs must also alert purchasers of particular insurance products (generally those aimed at retail clients) through their Product Disclosure Statement (PDS) that they are a foreign insurer and not authorised in Australia.

6.17 In addition, the conduct in relation to DOFI products is also subject to the consumer protection provisions of the Australian Securities and Investments Commission Act 2001 (ASIC Act) (for example, DOFIs are prohibited from engaging in misleading or deceptive conduct, misleading representation or unconscionable conduct in dealing with their clients).

6.18 Foreign insurers operating through a branch or subsidiary in Australia as authorised Australian general insurers are required to provide information on their activities under FSCODA. However, DOFIs that do not operate through such a structure are not subject to any information collection requirements on their activities in Australia.

Identification of options

6.19 There are three options to address the issues raised in relation to the regulation of DOFIs.

Option 1: Targeted prudential regulation

6.20 Under this option, anyone who is 'carrying on insurance business in Australia' either directly or through the actions of another would be required to become an authorised insurer under the Insurance Act and would be subject to Australian prudential regulation. The activities to be caught under this expanded definition are the activities up to and including entry into an insurance contract. These include: activities currently caught under the definition - undertaking liability and business incidental to undertaking liability - and actions of intermediaries, including inducing an Australian to enter into an insurance contract (for example advertising targeted at Australians). Australians who physically go overseas to take out insurance or who surf the internet and take out insurance that way will not be caught under the expanded definition.

6.21 The entities to be caught under this expanded definition of 'carrying on insurance business in Australia' are domestic insurers, foreign insurers currently operating via a branch or subsidiary, DOFIs (captives are a subset of any of these categories) and reinsurers authorised by APRA.

6.22 Foreign reinsurers will be exempt from having to be authorised in Australia, This approach would recognise that reinsurance is a global business. Australia does not have any domestic reinsurers at this time. Requiring offshore reinsurers to be authorised by APRA would severely limit the ability of Australian insurers to place part of their risk with reinsurers. This approach is in keeping with the international treatment of reinsurers, where they are regulated in their home jurisdiction. However, as noted above, APRA would regulate a domestic reinsurer established in Australia under the Insurance Act and any foreign reinsurer, who chooses to establish a branch or subsidiary in Australia. Foreign reinsurers who do not establish a branch or subsidiary in Australia would continue to be indirectly subject to the regulatory regime through the prudential standards applied to insurers.

6.23 Once captured under the regulatory regime, APRA will, in applying Australian prudential standards, use its current powers to tailor the application of those standards according to the insurer's risk profile, regardless of whether the insurer is a domestic or foreign insurer. These targeted prudential standards will take into account the insurer's customer base, home regulatory environment, ownership structure and type of business offered.

6.24 APRA would also make modifications to the existing prudential standards for insurers already authorised in Australia, depending on their client base and the type of entity providing the product. The exact modifications that would be made to the prudential standards will be developed in consultation with industry during the transition period.

6.25 Another key concern is to ensure that the regulation of DOFIs does not reduce the capacity for sophisticated policyholders (such as large corporations) to make their own insurance arrangements. To that end, there would be an exemption to the proposed regulatory regime for insurance business that cannot be placed in the Australian insurance market, either because of the nature of the risk, the capacity of the Australian insurance market or because there is simply insufficient expertise in Australia to assess that risk. This exemption would allow risks that could not be placed in the Australian market to be placed offshore with foreign insurers that are not APRA authorised under the Insurance Act.

6.26 As insurers authorised by APRA, DOFIs would continue to be subject to the consumer protection provisions in the Corporations Act outlined above and would be required to provide the same information to APRA as Australian domestic insurers under FSCODA. Information would also be collected from the financial intermediaries on the business they were placing with exempt DOFIs.

6.27 There would also be a prohibition on financial intermediaries that would prevent them from providing an insurance product from all but APRA authorised insurers or exempt insurers and collect information on the business financial intermediaries are placing with DOFIs.

Option 2: Potts review - comparable regime

6.28 Under this option, DOFIs marketing insurance in Australia would be exempt from prudential regulation in Australia if they were domiciled in a country APRA considers to have comparable prudential regulation, subject to a market significance threshold to prevent established authorised insurers moving offshore. DOFIs not meeting this test would be required to become authorised under the Insurance Act, if they wished to continue to conduct insurance in Australia.

6.29 PRA would also assume a information collection role in relation to DOFIs.

Option 3: No prudential regulation

6.30 Under this option, there would be no prudential regulation of DOFIs. However, they would still have to obtain an AFSL and comply with the disclosure requirements in the Corporations Act. They would not have to provide APRA with information on their activities in Australia. Foreign insurers with a branch or subsidiary in Australia would continue to be APRA-authorised and would be required to comply with the same requirements as all other Australian authorised general insurers.

Analysis of the impact of the options

6.31 The groups most affected by the regulation of DOFIs are: DOFIs; the Australian insureds that use DOFIs; financial intermediaries; Australian authorised insurers; and the regulators, APRA and ASIC.

6.32 In accordance with Government requirements, attached to this RIS is a Business Cost Calculator Quickscan Report outlining the costs to DOFIs of adopting the various options detailed in this RIS. A full cost report was not undertaken because, even though each option provides a regulatory framework, some of the detail within the framework have yet to be finalised. For example, if option 1 were to be adopted, APRA will spend a year developing its modified prudential standards in consultation with stakeholders and prepare a RIS at that stage of the process. Similarly, the collection of information from DOFIs and financial intermediaries would be undertaken after consultation with industry and APRA to determine exactly what information is required and how frequently.

Option 1

Option 1: Targeted prudential regulation

Benefits

DOFIs

6.33 DOFIs would have the substantial benefit that the regulatory requirements that they must comply with in their home jurisdiction would be taken into consideration by APRA in applying the Australian prudential standards. This would reduce duplication for the DOFI in complying with more than one prudential regime. For example, if the DOFI was part of a global corporate group and that group had a good risk management process, the DOFI may be able to satisfy the APRA prudential standard by applying this risk management process to its Australian business. The extent to which a DOFI's home jurisdiction is taken into account will depend on the home regulatory regime and the DOFI concerned. The more comparable a home jurisdiction is with the Australian prudential regulatory regime, the more APRA may be able to use that situation to satisfy Australian prudential standards.

6.34 In addition, APRA would also consider the clients of the DOFI in determining whether the DOFI has satisfied APRA's prudential standards. For example, a DOFI that is part of a global corporate group and that only provides insurance to other companies within the global corporate group may not need to hold as much capital in Australia, or meet other prudential standards to the same degree as a DOFI writing insurance lines for Australian retail insureds.

Australian insureds that use DOFIs

6.35 APRA will require all DOFIs that wish to operate in Australia to have, at a minimum, a presence in Australia and assets in Australia equal to their liabilities. This offers a significant benefit to Australian policyholders in that it protects them by ensuring that, in the event of the DOFI's collapse, they have an increased ability to access the assets of the insurer.

6.36 This option also has the significant benefit of allowing some sophisticated players in the general insurance market (for example, large corporations) to continue to access the global insurance market. In general, it does not affect commercial arrangements that the Potts review found had worked well to date and where the insureds is able to judge the risks involved in the transaction.

6.37 At the same time, Australians and most businesses would be dealing with an APRA-authorised insurer unless they had a risk that they could not place with such an insurer. In this case, they would still have the choice to either place the risk through a Lloyds underwriter or to seek an appropriate exemption in order to place the risk with a DOFI not authorised by APRA.

6.38 For DOFIs and their clients, this option would achieve the objective of ensuring that Australian policyholders are protected (that is, they are given a similar level of protection if they use a DOFI product or an Australian insurer's product). At the same time it recognises that there are some risks that cannot be placed in Australia and allows Australians to access the overseas market. Targeted prudential regulation will allow DOFIs to gain authorisation using their risk profiles. This will ensure DOFIs are not overregulated.

Australian authorised insurers

6.39 This option would require all insurers providing insurance products in Australia to be subject to the same prudential standards (including the capital adequacy requirements) and required to have a presence in Australia. This approach would have a significant benefit for Australian authorised insurers as they will no longer be at a regulatory disadvantage (that is, forced to comply with more stringent regulation compared with DOFIs). In addition, it would be much easier to enforce collection from DOFIs of those insurance taxes currently collected from Australian general insurers, because they would have a local presence. This would eliminate the competitive advantage that Australian insurers argue DOFIs have gained from it being very difficult to enforce the collection of state taxes against these DOFIs. (State and Commonwealth taxes may not be being collected for many insurance policies they write, resulting in a lower premium price.)

Financial intermediaries

6.40 Financial intermediaries would benefit by being confident that, when they place business with an authorised insurer, APRA is monitoring the insurer's financial soundness, client's claims are paid out when they occur and clients are able to access funds in the event that the insurer collapses.

6.41 However, financial intermediaries also have a significant benefit in that they would continue to be able to access the global insurance market for their large commercial clients and would be able to place risks that could not be insured in Australia offshore.

Regulators - APRA/ASIC

6.42 For APRA there would be greater clarity about the application of the legislation. A number of stakeholders consulted expressed frustration with the definition of 'carrying on insurance business in Australia' and the difficulty that lay in determining when a DOFI has met the test. Under this option, a DOFI would be required to be authorised if it is directly, or through the actions of another, 'carrying on insurance business in Australia'. In addition, the actions of the financial intermediary, to the extent that they target Australians to enter into contracts with DOFIs, would be brought under the expanded definition of 'carrying on insurance business in Australia'.

6.43 Given that it would be easier to identify who is regulated under this option, it would be easier to identify where there was a DOFI acting in breach of the Insurance Act and to take action against that entity.

6.44 Finally, because DOFIs that wish to operate in Australia would require a local presence, it would be easier for APRA to enforce its prudential standards against the DOFI. This is because there would be a responsible officer subject to the penalties under the Insurance Act.

6.45 This option would mean that information collection under FSCODA would automatically apply. As Australian authorised general insurers, they would already be captured under the current regime.

Costs

DOFIs

6.46 This option also has a potentially significant cost for DOFIs, as it would require all DOFIs to be authorised by APRA. That means that all DOFIs who wanted to continue carrying on business in Australia, have to apply for an APRA licence and comply with the reporting and prudential standards APRA sets for them, outlined above. These costs would be significant for the DOFIs.

6.47 DOFIs would also be required to apply to become authorised. The current licence application fee of $68,200 provides an estimate of authorisation costs.

6.48 DOFIs would also have ongoing APRA reporting costs. The current general insurance levies provide an estimate of these costs, in the absence of better information. The following excerpt from the Financial Sector Levies Discussion Paper provides a basis for the estimate.

6.49 For those DOFIs that provide professional indemnity and public liability cover there would also be the NCPD levy. The NCPD levy is a function of an institution's premium income in those classes, as detailed in the following excerpt from Financial Sector Levies Discussion Paper dated May 2006:

Australian insureds that use DOFIs

6.50 Anecdotal evidence from brokers suggests that a number of DOFIs may cease operating in the Australian market, as the cost of meeting Australia's prudential regulations would outweigh the benefits, especially where the DOFI is only writing a small volume of business in Australia. This may result in lower capacity in the Australian market, particularly in niche markets, and less choice for Australian insureds. This has potential consequences for some Australian insureds, who may have difficulty obtaining insurance cover.

6.51 Once DOFIs are authorised by APRA, it would be possible to enforce Australian taxes on DOFIs and they must comply with Australian prudential standards, these costs may result in premium increases for some Australian insureds. However, there is insufficient information currently available on DOFIs to be able to ascertain the extent of any such increase.

Australian authorised insurers

6.52 There may also be small costs for local Australian domestic insurers as they adapt to the modified prudential standards that apply to them under this approach. However, it is envisaged that the standards would be modified to reduce the costs on certain types of insurers to take into account their risk profile. It is not envisaged that any strengthening of existing standards would occur under this process. Domestic insurers would be able to choose whether to continue to be bound by the stricter standards or comply with the modified standards.

Financial intermediaries

6.53 It may also create some costs for financial intermediaries, who will be unable to provide insurance products from unauthorised DOFIs to some of their clients. However, the costs are difficult to estimate, given that there is insufficient information on the amount of insurance business placed with DOFIs and the number of these DOFIs that may cease operating in Australia.

Regulators - APRA/ASIC

6.54 This option would also impose a number of administrative costs on APRA, as it would be required to process applications from DOFIs for Australian licences. In addition, it would have to monitor these DOFIs and ensure that they comply with Australian prudential standards, or enforce their compliance.

6.55 APRA estimates the costs of establishing modified prudential regulation standards at $500,000 to $1 million.

6.56 APRA would also require additional resources and expertise to monitor the exemption and collect information on what risks are being placed offshore through that mechanism.

Option 2

Option 2: Potts Review

Benefits

DOFIs

6.57 This option has a significant benefit for reputable DOFIs and their members in that it would target those DOFIs that pose the greatest risk of collapsing, because they are not subject to comparable prudential regulation in their home jurisdiction. DOFIs from countries with comparable prudential regulation would be able to rely on their home jurisdiction and not become APRA authorised. This significantly reduces the compliance costs for well-regulated DOFIs; they do not need to apply to APRA for a licence to carry on insurance business in Australia; they are not required to hold a minimum level of capital in Australia; and they are not subject to Australia's consumer protection, financial reporting and information collection provisions.

Australian insureds that use DOFIs

6.58 The approach would ensure that well regulated DOFIs would continue to write business in the Australian market and would not create a barrier to these DOFIs continuing to supply their products to Australians. This would have the substantial benefit of having continuing competition in the Australian market. In some specialised niche markets, where only overseas insurers operate, Australian insureds would be able to access those lines directly or through a financial intermediary. While the risk posed by DOFIs from well regulated regimes is lower than for other DOFIs, the well regulated regime will still not provide the same level of protection to Australian insureds as the Australian prudential regulatory regime. Authorised insurers are required to maintain assets at least equal to Australian liabilities. On the liquidation of an authorised insurer, Australian liabilities must be settled from those Australian assets before foreign liabilities can be settled from those Australian assets. This protection will not be available to insureds, who use DOFIs, irrespective of the home regulatory regime.

6.59 In addition, as these DOFIs are exempt from the Australian prudential regulatory regime they may be able to offer their products to Australians at a lower price than Australian insurers, although this is offset against the cost of complying with comparable home jurisdiction regimes. The extent to which state insurance taxes are being collected on DOFI insurance policies is not clear. Insurers argue limited state insurance taxes are currently being collected on DOFI insurance policies. Maintaining competition from DOFIs may result in lower costs to Australians.

Australian authorised insurers

6.60 There is no direct benefit from this option for Australian authorised insurers, although it would have the indirect benefits of removing competition from DOFIs from non-comparable regimes.

Financial intermediaries

6.61 This option would also allow financial intermediaries to source a range of products from global well-regulated insurers, thereby allowing them to find and negotiate with insurers to provide a targeted solution for their clients.

Regulators - APRA/ASIC

6.62 There would be no direct benefits to APRA and ASIC of this option. Costs

DOFIs

6.63 Consultations with stakeholders suggested that it was very difficult to determine which countries would have a prudential regulatory regime comparable with that of Australia. There are significant risks associated with this approach for the DOFI, in that it is unclear what constitutes a comparable regime and how comparability will be measured. Moreover, it also creates uncertainty because it is not clear what a home jurisdiction must do for APRA to deem its prudential regime to be comparable with that of Australia.

6.64 DOFIs from regimes that APRA did not consider comparable would have the costs of becoming APRA-authorised and complying with Australian prudential standards (including holding capital here and having a presence in Australia) or alternatively withdrawing from the market.

Australian insureds that use DOFIs

6.65 If DOFIs from well-regulated regimes are not required to have a presence in Australia or to hold capital here, it would be very difficult for Australian insureds to get access to capital in the event that the DOFI collapses or where a claim is not paid. Even if the DOFI does not collapse, there may be no capital in Australia that the Australian courts can access to pay out a policyholder's claim. In this situation, the Australian policyholder would need to take action against the DOFI in a foreign court.

6.66 This would be a significant risk for the Australian policyholders, particularly small businesses and retail clients who may not understand the significance of the DOFI not being regulated in Australia and having assets here until their claim goes unpaid. Although the exact number of DOFIs that have collapsed or refused to pay out claims is not known, ASIC has applied to the court to wind up or stop DOFIs from operating in Australia on several occasions in the past couple of years.

Australian authorised insurers

6.67 DOFIs from well-regulated regimes may be able to provide their product at lower prices because they do not need to comply with Australian prudential standards. The cost of complying with prudential standards in their home jurisdiction may be less than the cost for Australian insurers of complying with the Australian prudential standards. Also, it may be difficult to enforce the same state insurance taxes faced by Australian insurers. Australian authorised insurers argue this is a significant cost and that this results in DOFIs obtaining a competitive advantage. This may result in Australian insurers losing market share to DOFIs and in some cases getting out of particular lines of insurance altogether. It may also encourage Australian insurers that have overseas subsidiaries to transfer their business offshore, so as to take advantage of the competitive advantage enjoyed by well-regulated DOFIs.

6.68 Reduced competition in the Australian insurance market would be likely to have a cost to Australians, as they would have fewer products to chose from when placing their risk and the products that remain may offer fewer protections. In addition, reducing the size of the Australian insurance market may also affect Australia's reputation overseas for having a well-regulated, robust and competitive general insurance market may be compromised by the proposal. This may have an impact on Australian insurers with foreign operations.

Financial intermediaries

6.69 Financial intermediaries would have the additional costs of having to determine whether the insurer they were recommending to their clients came from a comparable regime or not. They would need to determine whether that DOFI needed to be APRA authorised. In addition, they would need to continue to monitor that DOFI and its home jurisdiction to ensure the DOFI continued to be exempt from having to comply with the Australian prudential regime. Although not a significant cost for brokers, depending on how the system was set up, it nonetheless would require brokers to devote resources to ongoing monitoring.

Regulators - APRA/ASIC

6.70 If this option is adopted, APRA would have the significant costs of establishing a regulatory regime to cover DOFIs. Those from a robust prudential regime would be exempt and all other DOFIs would be required to become APRA authorised. This creates a separate regime that APRA would enforce and monitor, increasing complexity for both the DOFIs and the system of insurance regulation more generally.

6.71 The costs of Option 1 would be the same as for Option 2 with the additional ongoing costs of assessing and maintaining up to date knowledge of foreign regulatory regimes. APRA estimates this ongoing cost to be $2 million to $4 million per year.

6.72 In order to provide a robust regime under this option APRA envisages needing an additional cell of dedicated staff and a considerable amount of international participation in on-site supervision work with offshore regulators.

Option 3

Option 3: No prudential regulation

Benefits

DOFIs

6.73 This option is the current position. It has the advantage that there would be no additional compliance costs on those DOFIs that do not choose to establish a branch or subsidiary in Australia. It allows all DOFIs to operate in the Australian market, so long as they or their financial intermediary have an AFSL.

Australian insureds that use DOFIs

6.74 This option provides Australians and financial intermediaries with a major benefit as they would have the broadest range of products from which to choose when placing their risk. The fact that many of these DOFIs do need to pay state taxes, but those taxes are not enforced, means that they can provide their products at lower prices to Australian consumers.

Australian authorised insurers

6.75 There would be no direct benefits to Australian insureds from this option.

Regulators - APRA/ASIC

6.76 There would be a lower administration costs on APRA, as APRA would not be required to prudentially regulate DOFIs. Although, given that APRA does not regulate DOFIs now, it is only a benefit from the perspectives of the two other alternative options being considered.

Costs

DOFIs

6.77 There would be no direct costs to DOFIs from this option.

Australian insureds that use DOFIs

6.78 This approach would have significant costs for Australian policyholders. It leaves them unprotected in the event that the DOFI collapses. Australian insureds, especially Australian retail clients, may have difficulty ascertaining the financial soundness of an overseas insurer. The fact that they are from a comparable regime does not directly indicate the financial soundness of the insurer.

6.79 Similarly, the fact that a DOFI is from a robust prudential regime does not assist Australian insureds in the event that the insurer collapses. In that situation, Australian insureds may have difficulty in recovering the money they paid in premiums or having their claims paid. Depending on the jurisdiction, it may be difficult to have an Australian court judgment enforced against the assets of the insurer. This would particularly be the case in countries where priority is given to domestic policyholders over foreign policyholders.

Australian authorised insurers

6.80 For domestic insurers, the ability of DOFIs to access the market and yet not be prudentially regulated or pay the same state insurance taxes creates a significant competitive disadvantage and cost for Australian authorised insurers. This can lead to a reduction in an Australian domestic insurer's market share and at the margins of the industry create an incentive for some Australian insurers to move offshore.

6.81 Although the exact number of DOFIs that have collapsed or refused to pay out claims is not known, ASIC has applied to the court to wind up or stop DOFIs from operating in Australia on several occasions in the past couple of years.

Regulators - APRA/ASIC

6.82 Finally, the regulators may also face criticism in the event that a DOFI collapses and are likely to have substantial reputational costs.

Consultation

6.83 The Government has undertaken two public inquiries into the regulation of DOFIs and their role in the general insurance industry, as well as continual consultation with key stakeholders over the last three years.

6.84 The first public inquiry was the Potts review that took place in 2003. The Potts review sought submissions from the public on the extent and nature of DOFI operations in Australia and their contributions to overall risk capacity. The Potts review received 19 submissions from a range of stakeholders including DOFIs, Australian authorised general insurers, captives, reinsurers, brokers and agents, industry associations, state governments and the regulators, ASIC and APRA.

6.85 In response to the comments of these submissions, the Potts review developed its key recommendations, which were accepted by the Government in May 2004. In December 2005, Treasury released a public discussion paper seeking comments from all interested stakeholders on how to implement the Potts review recommendations. It received 28 submissions from a range of stakeholders, including Australian insurers, reinsurers, captives, DOFI, brokers, industry association, the regulators ASIC and APRA and a number of state governments.

6.86 Throughout this period, Treasury has also consulted with interested stakeholders. It has held a number of meetings with DOFIs, insurers, brokers and the regulators both to better understand DOFIs, their role in the Australian general insurance market and how to regulate them but also how to practically implement the Potts Review recommendations.

6.87 From the various submissions and discussion held with key stakeholders varying views emerged, although most stakeholders have held largely consistent views throughout the consultations to date.

6.88 Australian authorised insurers believe that DOFIs should be subject to the same prudential and regulatory requirements as domestic insurers. In particular, they argue that DOFIs should be required to hold capital in Australia and establish a presence here. Australian authorised insurers are particularly concerned about DOFIs obtaining a competitive advantage by not being required to hold capital here and Governments not being able to enforce the collection of Australian taxes on their insurance policies that cover Australian risks.

6.89 DOFIs, on the other hand, believe that APRA should not disadvantage overseas insurers from operating in Australia if they are established in a comparable prudential regime. DOFIs from comparable regimes do not believe that they should be prudentially regulated in Australia as they are already subject to prudential regulation in their home jurisdiction.

6.90 Financial intermediaries do not believe that foreign insurers should be prudentially regulated in Australia. Instead, they believe that the disclosure requirements applying to DOFIs should be strengthened. Australian financial intermediaries suggest they should be required to disclose to all their clients, regardless of whether these clients are retail or wholesale clients, that the DOFI is not APRA authorised and that they may not be able to enforce their claims against the DOFI or access funds to pay their claims if the DOFI collapses.

6.91 In developing the options in this regulation impact statement, the concerns of insurers to have a level playing field and protect consumers, the concerns of brokers to able to continue to access insurance products to meet the needs of their clients and the concerns of DOFIs from robust prudential regulatory regimes not be subject to regulatory duplication were all taken into consideration.

Conclusion and recommended option

6.92 Option 2 was rejected as being unworkable because stakeholders' submissions during the consultations suggested that it would be very difficult, if not impossible, to determine what constituted a comparable regime; that is, the criteria that would be used to make that assessment. It would also create added complexity in the regulation of insurers in Australia because it would create another regime to regulate DOFIs.

6.93 Stakeholder comments indicated that some form of regulation for DOFIs was required to protect Australian insureds and third party beneficiaries from a DOFI not paying claims and/or collapsing and not paying claims. Also, DOFIs enjoy a competitive advantage over Australian insureds, in not maintaining a presence in Australia or being subject to APRA's prudential standards, particularly the capital requirements. As a result, option 3 was rejected as it did not address these two concerns.

6.94 Given the above comments and the analysis, option 1, targeted prudential regulation, is recommended. This option allows APRA to take into consideration the range of unique risk factors associated with each insurer that seeks to operate in the Australian market, while at the same time ensuring that at a minimum there is sufficient capital in Australia to cover Australian insureds liability in the event that an overseas insurer fails. It also ensures that information is collected on the role of DOFIs in the general insurance market so that APRA can develop increasingly targeted prudential standards.

Implementation and review

6.95 It is proposed that option 1 be implemented through legislative amendments to the Insurance Act, Corporations Act, Corporations Regulations and FSCODA.

6.96 The definition of insurance business in the Insurance Act would be amended to cover the expanded activities and entities described above. There may also need to be an exemption from needing to be authorised for foreign reinsurers and an additional exemption for insurance business that cannot be placed in the Australian market.

6.97 In addition, to ensure that APRA can enforce option 1, APRA's existing powers under the Insurance Act to:

•

require production of information, books, accounts or documents;

•

access premises; and

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initiate investigations

would be expanded to include persons APRA reasonably believes are carrying on insurance business in Australia without authorisation or aiding, abetting, procuring or counselling a second person to carry on insurance business in Australia without authorisation.

6.98 In addition, APRA would be given a power to seek restraining, consent and interim injunctions from the Federal Court with respect to unauthorised insurers and persons involved in the activities of unauthorised insurers. This power would enable APRA to act quickly in situations where unauthorised insurers are carrying on insurance business in Australia. The injunction power would only permit APRA or any person whose interests are affected by the conduct of the entity to seek an injunction.

6.99 The administration costs associated with these enforcement measures would be met out of APRA's existing budget.

6.100 Insurers and financial intermediaries consulted have acknowledged the need to expand APRA powers under the Insurance Act to ensure that APRA has sufficient power to effectively monitor and ensure compliance with the proposed DOFI regime.

6.101 APRA would develop its modified prudential standards in consultation with Treasury and stakeholders, including existing APRA authorised insurers, DOFIs and financial intermediaries.

6.102 No changes will need to be made to the consumer protection provisions of the Corporations Act. As an APRA-authorised insurer, DOFIs will be subject to the same consumer protection provisions that currently apply to Australian general insurers under the Act.

6.103 However, it is also proposed that a prohibition would be inserted in the Corporations Act preventing Australian financial service licence holders from providing a general insurance product to their clients that is not from an Insurance Act authorised or exempt insurer. The enforcement powers that ASIC already has under the ASIC Act will be used to enforce the prohibition.

6.104 No changes will need to be made to FSCODA to collect information from DOFIs as they will fit within the category of APRA regulated entities already in the Act. However, it is proposed that the Corporations Act be amended to allow ASIC to collect and provide to APRA information from financial intermediaries on the business they are placing with DOFIs.

6.105 As it will require time for APRA to develop its modified prudential standards and DOFIs currently operating in the Australian market will need time to apply for authorisation, it is proposed that the new regulatory regime commence on 1 July 2008. This provides APRA with a timer to develop its modified prudential framework in consultation with industry and for DOFIs to apply to become authorised.

Direct Offshore Foreign Insurers Quickscan report

What is the problem you wish to address?

The current regulatory treatment of foreign insurers operating in Australia lacks consistency. Foreign insurers are treated in different ways depending on whether they are: foreign insurers authorised by APRA operating in Australia; Lloyd's underwriters authorised under special provisions of the Insurance Act; or unauthorised foreign insurers conducting business in Australia directly or through agents or brokers. Foreign insurers not authorised in Australia may be domiciled in jurisdictions with different regulatory regimes. This means that the degree of protection afforded to policyholders with similar insurance risks would vary depending on the country of origin of the insurer selected.

At the same time, however, there is a concern to that commercial arrangements that have worked satisfactorily to date not be prohibited.

What is the objective of the policy?

The policy objective is to ensure that policyholders with exactly the same risk are afforded the same degree of protection regardless of the origin of their insurer, while ensuring that commercial arrangements that have worked satisfactorily to date are not prohibited.

Businesses Affected:

exact numbers of DOFIs affected is not known due to the lack of information. Anecdotal evidence from financial intermediaries suggests between 10-50.

Supporting evidence for the following options:

Information is not currently available on the number of DOFIs operating in the Australian market. As a result, it is not possible at this time to accurately calculate the costs to DOFIs of the various options outlined below. However, the classes of costs to DOFIs are described below and in the RIS.

Level of certainty for the following options:

Low - Medium

Option 1 - Targeted prudential regulation

Under this option, all DOFIs would be subject to full Australian prudential regulation, that is they would be required to be licensed under the Insurance Act and meet prudential requirements. However in applying the prudential standards APRA would use its current powers including discretionary and exemption powers to tailor the application of those standards according to the DOFI's risk profile. These tailored prudential standards will take into account the insurer's customer base, home regulatory environment, ownership structure and type of business offered.

As APRA authorised insurers, DOFIs would continue to be subject to the consumer protection provisions in the Corporations Act and would be required to provide the same information to APRA as Australian domestic insurers under FSCODA. Information would also be collected from the financial intermediaries on business placed with DOFIs.

Option 2 - Comparable regime

Under this option DOFIs marketing insurance in Australia would be exempt from prudential regulation in Australia if they are domiciled in a country APRA considers to have comparable prudential regulation, subject to a market significance threshold to prevent established authorised insurers moving offshore. DOFIs not meeting this test would be able to market insurance in Australia as an authorised insurer through a branch or subsidiary.

APRA would assume an information collection role in relation to offshore insurers.

Option 3 - Status quo

Under this option, there would be no prudential regulation (that is, no requirement for the DOFI to establish a presence or have assets in Australia etc.) of DOFIs. However, they would continue to have to obtain an Australian financial services licence and comply with the disclosure requirements in the Corporations Act. They would not have to provide APRA with information on their activities in Australia. Foreign insurers with a branch or subsidiary in Australia would continue to be APRA authorised and would be required to comply with the same requirements as Australian authorised general insurers.