House of Representatives

Explanatory Memorandum

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

Chapter 5 Regulation impact statement: Discretionary Mutual Funds

Background

5.1 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.

5.2 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.

5.3 As their name suggests, DMFs offer 'discretionary cover', that is, an insurance-like product that does not involve a contractual obligation to meet the costs if a risk eventuates. At its discretion, the provider will consider meeting the costs. DMFs provide a means of risk management that is an alternative to insurance. DMFs sometimes meet risks for which commercial insurance may not be available or affordable. DMFs benefit from cost advantages, compared to authorised insurers, due to their exemption from state taxes and, to a lesser degree, prudential regulation. It is not clear whether their recent growth (although still a small proportion of the market) is due to their lower costs or demand for tailored products that commercial insurers do not provide.

5.4 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.

5.5 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.

5.6 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.

5.7 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.

5.8 The Potts review noted there was no comprehensive industry or Government information available on DMFs. However, based on the limited information that was available, the Potts review estimated that DMFs were unlikely to represent more than half of one percent of the insurance market. The Potts review found that during the 1980s, DMFs were generally restricted to legal mutuals established under state legislation for solicitors, medical indemnity organisations, some local government pools operating as unincorporated mutuals and a university mutual. In the 1990s the number of DMFs steadily increased in response to market opportunities. This trend was accelerated by the hardening of the insurance market in 2001, especially in long-tail public liability lines.

Problem identification

5.9 DMFs provide discretionary cover. This means that there is no legal obligation by the provider to meet the costs of an 'insured' event. The DMF merely accepts that it will, at its discretion, consider meeting such costs. An insurer, on the other hand, assumes an obligation to pay the insured on the happening of an event covered by the terms and conditions of the insurance contract.

5.10 Membership subscriptions form a pool of funds to meet claims by DMF members. Some DMFs buy insurance top up and drop down cover to supplement the pool funds, to meet large or numerous claims. Some DMFs may make a call on their members if there is insufficient funds to cover the liabilities incurred by the members.

5.11 DMFs do not pay state insurance taxes on the DMF fund because they are not offering insurance products. However, they do pay state insurance taxes on any insurance cover they take out to cover the risk products they offer. Insurance taxes can add up to more than a third of the cost of the insurance product.

5.12 Both the HIH Royal Commissioner's report and anecdotal evidence suggest that purchasers of DMFs' products may not be aware that they are not purchasing insurance. Anecdotal evidence suggests that in some cases the purchaser of a DMF product, the DMF member, is driven more by consideration of price. The DMF member may not fully understand the discretion that the DMF may exercise, nor the mutual rights and obligations that flow from pooling funds to cover a member's particular risk (including the possibility of a call on members if there are insufficient funds in the pool). They may expect that the DMF will cover any claims and may not understand that the DMF has discretion to accept or refuse to pay a claim.

5.13 In addition, as DMF products are not insurance, DMFs are not subject to the prudential requirements in the Insurance Act. As a result, some argue that DMFs have a greater risk of collapsing or of being forced to exercise their discretion against paying claims because they have insufficient funds. This would leave the DMF member to meet the cost of any claim, potentially creating hardship in funding the claim and leaving a third party beneficiary without compensation (albeit only where the member has insufficient funds and the risk insured has a third party beneficiary).

5.14 Because DMFs are not subject to the prudential standards in the Insurance Act (particularly the capital requirements) and state insurance taxes (to the extent of the DMF fund), there is a concern that they may have a competitive advantage over insurers. Insurers have argued that in some lines this competitive advantage has led to the withdrawal of domestic insurers and that in other lines it is very difficult for insurers to compete with a DMF. However, DMFs have argued that they cover risks that Australian insurers choose not to insure, or not to insure at an affordable price.

5.15 To address these problems, Government action is required to ensure that Australians have information regarding the characteristics of the product they are contemplating purchasing, so that they are making an informed risk management choice. Those characteristics include the discretion the DMF may exercise and the mutual rights and obligations of belonging to a DMF, in some cases this may include the ability of the DMF to place a call on its members.

5.16 In addition, Government action is required to ascertain whether or not DMFs pose a greater prudential risk because they are not subject to prudential standards.

Objectives

5.17 The objective of Government action is to ensure that Australians have a range of risk management tools available to them and information about the characteristics of the options they are considering, so that they are in a position to make an informed decision on how to best manage their own risks.

5.18 At the same time, the Government is seeking to maintain not only contestability, competitiveness and innovation in the insurance sector and community confidence in the Australian general insurance market, but also Australia's reputation as a sound, well-regulated insurance market.

5.19 Currently, DMFs are generally subject to the financial services provisions within the Corporations Act and are regulated by the Australian Securities and Investment Commission (ASIC). As they carry on a financial services business (that is, they deal in a financial product, they manage financial risk), they are required to hold an Australian Financial Services Licence (AFSL) and comply with the disclosure requirements for retail clients. For example, they are required to disclose key characteristics of their product in the Product Disclosure Statement (PDS) they are required to provide to retail clients.

5.20 Neither the Corporations Act, nor the Corporations Regulations, specifically identify what the key characteristics of a DMF product are and, therefore, what DMFs must disclose to a potential client. As a result, it is possible that DMFs may not inform potential retail clients about the DMF's discretion to pay claims and the mutual rights and obligations that flow from being a DMF member, including, in some cases, the DMF's ability to place a call on its members.

5.21 The requirement to disclose the key characteristics of a DMF product to clients is limited to retail clients. A business that does not manufacture products and that employs more than 20 people is not a retail client. This means that, under the Corporations Act, the DMF does not need to disclose the characteristics of its product to potential wholesale members. Small businesses which may be just above the retail test (for example, they employ 22 people instead of 20) may not understand the characteristics of the DMF product. Anecdotal evidence suggests that a large number of many DMFs' wholesale clients may fit this example. In practice many DMFs, particularly those with retail and wholesale clients, will provide both classes of client with the same information. However, this is unlikely to occur where the DMF has no retail clients.

5.22 In addition, most DMFs are considered managed investment schemes (MIS) and as such are required to be registered as one under Chapter 5C of the Corporations Act with ASIC.

5.23 The conduct in relation to DMF products is also subject to the consumer protection provisions of the Australian Securities and Investments Commission Act 2001 (for example, DMFs are prohibited from engaging in misleading or deceptive conduct, misleading representation or unconscionable conduct in dealing with their clients).

5.24 DMFs are also subject to the broader regulatory environment. That is, DMFs are generally established as either a corporation limited by guarantee or trust fund. In both cases, 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.

Identification of options

5.25 There are four options to address the issues raised in relation to the regulation of DMFs.

Option 1: Full prudential regulation

5.26 Under this option, DMFs would be required to become Australian authorised general insurers under the Insurance Act in order to continue operating. As an Australian authorised general insurer, they would be subject to the consumer protection provisions that apply to general insurers under the Corporations Act and Insurance Contracts Act 1984 and APRA would collect information from them under FSCODA.

5.27 DMFs would be required to apply to APRA to become authorised Australian general insurers. They would be required to provide information on their ownership, board and management, a three-year business plan, the structure of their business, their financial projections and a risk management and reinsurance management strategy. They would have an ongoing obligation to comply with Australian prudential standards, that is, they would be required to hold capital equal to the minimum capital requirement and have assets in Australia equal to their liabilities. The DMF would also need to satisfy APRA that the directors and senior managers were eligible to hold key positions within their organisation. They would also need to appoint an auditor, and possibly an actuary, approved by APRA. They would also need to satisfy APRA that their proposed risk management and control systems were adequate and appropriate for monitoring and limiting the risk exposures in relation to their operations (including balance sheet and market risks, reinsurance risks, liability risks and capital management risks). APRA has indicated that it believes that imposing solvency requirements on a discretionary vehicle could be difficult so DMFs would have to restructure so as to offer contractual insurance coverage.

5.28 Under the Corporations Act DMFs, as insurers, would be required to provide PDSs to their retail clients. For general insurers, retail clients are individuals or small business seeking a motor vehicle, home building, home content, consumer credit, sickness and accident, travel or personal or domestic insurance product.

5.29 Under the FSCODA, DMFs, as insurers, would be APRA-regulated entities and as such they would be required to provide information on a quarterly basis to APRA.

Option 2: Potts review recommendation - no contingent risk

5.30 Under this option, the Government would implement the Potts review recommendations that required discretionary mutual cover to be offered only as a contract of insurance under the Insurance Act, except where APRA considered that the DMF had no contingent risk that would need to be met by additional undefined member contributions. (Such risks would fall on a general insurer providing top up or drop down cover.) APRA would also be required to collect information on business written by DMFs under the exemption.

5.31 Under this option, all DMFs would have to submit information to APRA on an ongoing basis, at least annually, so that APRA could assess whether or not the DMF retained any contingent risk. This information is likely to include information on the structure of the DMF, the amount of money the DMF retained in its fund, information on the products it provided to members and copies of the insurance policies it had taken out to cover any claims in excess of its fund.

5.32 APRA would decide whether or not the DMF retained any contingent risk. If it found that the DMF did retain contingent risk, APRA would require the DMF to either cease providing the product or to set up as an insurer and comply with all the requirements detailed above in option 1, including the consumer protection and information collection requirements and the potential for a restructure of the DMF and its product offerings. APRA would have responsibility for ensuring that the DMF complied with its assessment. If, however, APRA determined that the DMF did not retain any contingent risk, then it would not prudentially regulate the DMF. DMFs would still be required to have an AFSL and comply with the consumer protect provisions in the Corporations Act that currently apply to them.

5.33 DMFs would also, depending on how they were structured, still be required to comply with the general Corporations Act provisions that apply to corporations or trust law obligations that apply to trusts.

5.34 In addition, if the DMF was not APRA-regulated it would still be required to submit information to APRA on an ongoing basis under the FSCODA APRA would enforce the provisions of the FSCODA. APRA would be likely to require information on the number of members, premium income, lines of business, insurers and additional information on its financial statements.

Option 3: No prudential regulation at this stage but collect information and strengthen consumer protection and commence a review within three years after implementation

5.35 Under this option, DMFs would not be prudentially regulated at this stage. However, DMFs would continue to be subject to the consumer protection provisions of the Corporations Act and the provisions that apply to DMFs' clients would be strengthened and extended to DMFs' wholesale clients. DMFs would also become subject to the FSCODA. The Government would review within three years after implementation these provisions to determine whether or not to prudentially regulate DMFs.

5.36 DMFs would also, depending on how they were structured, still be required to comply with the general Corporations Act provisions that apply to corporations or trust law obligations that apply to trusts.

5.37 The FSCODA would be amended so that it applies to DMFs. APRA would collect information on the risks DMFs cover, the volume of business and any additional information (for example, information on their structure) that would assist the Government in determining whether or not DMFs need to be prudentially regulated, including information on the DMF's financial statements.

5.38 Information would also be collected from Australian financial service licence holders who promote or develop DMFs through an amendment to the Corporations Regulations.

5.39 Consumer protection provisions would be strengthened by inserting a regulation into the Corporations Regulations to specify information a DMF must provide to its members before they join the fund. This would include information on the mutual rights and obligations that flow from becoming a member of a DMF, whether and to what extent they would be subject to a call, the discretionary nature of the product they are purchasing and how the rules governing their membership could be altered.

Option 4: Status quo - no prudential regulation

5.40 Under this option, the current arrangements regarding DMFs would continue. DMFs would not be prudentially regulated. ASIC would continue to regulate DMFs under the Corporations Act as an AFSL holder and they would be required to comply with the Corporations Act disclosure requirements for retail clients. For example, they are required to disclose key characteristics in their PDSs to retail clients.

5.41 DMFs would also, depending on how they were structured, still be required to comply with the general Corporations Act provisions that apply to corporations or trust law obligations that apply to trusts.

Analysis of the impact of the options

5.42 The groups most affected by the regulation of DMFs are: DMFs, DMF members, insurers and the regulators, APRA and ASIC.

5.43 In accordance with Government requirements, attached to this RIS is a Business Cost Calculator Quickscan Report outlining the costs to DMFs of adopting the various options detailed in this RIS. A full cost report was not undertaken due to the lack of information available on the number of DMFs operating in the Australian risk market and their role.

Option 1

Option 1: Full prudential regulation

Benefits

DMFs

5.44 DMFs would benefit from prudential regulation through their increased financial stability and implied endorsement by APRA. DMFs would be APRA regulated as general insurers and this implies that the regulator assesses the entity as solvent and that the claims of policyholders will be honoured in all normal circumstances.

5.45 In addition, to the extent that they were APRA-regulated entities providing their financial services to wholesale clients only they would be exempt from the requirement to hold an AFSL. DMFs who meet the above criteria would have cost savings because they would not have to obtain an AFSL or meet the ongoing compliance obligations imposed on AFS licensees, for example the requirement to provide a PDS to their clients. The number of DMFs that may only have wholesale clients and so benefit from this exemption is not known.

DMF members

5.46 Potential and existing DMF members would benefit from the prudential regulation of DMFs as they would not need to understand the unique rights and obligations associated with being a member of a DMF or the discretionary nature of the DMF product they were purchasing. Under this option, DMFs would become insurers and offer insurance policies.

5.47 DMF members would be assured that if an event covered by the DMF occurred, they would be covered for that loss according to the terms of the insurance contract. The DMF would not have any discretion to reject a claim meeting the policy's terms and conditions.

5.48 Furthermore, DMF members would not be subject to any additional calls, as there are no calls on the holder of a insurance policy. As a result, there would be more certainty for the DMF members about the price they pay for their cover. (However, most DMFs that can call on their members explicitly outline the percentage of total premiums they can seek in a call when the DMF member purchases the DMF product.)

5.49 The increased certainty that a claim that met the terms and conditions of the policy would be paid out would flow on to third party beneficiaries. If a third party beneficiary suffered a loss as a result of the action of a DMF member that was within the terms of that member's insurance cover, they would be compensated by the insurer. They would not have to rely on a fund, with a discretion, deciding whether or not to pay their claim or, if it did not, on the capital of the DMF member. (However, this benefit is limited by the fact that generally there is no requirement to take out insurance.)

5.50 DMF members and third party beneficiaries would also benefit from the protections in the Insurance Act, the Insurance Contracts Act and the Corporations Act that apply to general insurers. For example, under the Insurance Act, DMF members and third party beneficiaries benefit from the prudential requirement that insurers must keep sufficient assets in Australia to cover their liabilities. In the event of a failure of a fully regulated DMF, the assets maintained in Australia are to be used to pay claims to Australian creditors before being available to other creditors.

5.51 Third party beneficiaries would also have the benefit under the Insurance Contracts Act that certain insurance policies provide the right to have their claim paid out even if the insured disappears. Again, this is a benefit only to the extent that a DMF member takes out insurance to cover the risk previously covered by the DMF.

Insurers

5.52 Insurers would benefit from a requirement for DMFs to become authorised insurers as some DMFs that cannot or would not comply with APRA prudential standards would exit the market. DMF members currently using DMFs to manage their risks would have to either self insure or seek replacement cover from an insurer. A number of these DMF members are likely to seek insurance cover to replace the risk cover they obtained from the DMF. This would increase the market share for insurers. The exact benefit to insurers would depend on the number of DMFs that cease operations. This may lead to reduced competition in particular lines of insurance business.

5.53 Brokers, too, would also be likely to benefit. Former DMF members or people requiring cover for difficult to place risks may approach brokers for assistance in finding replacement cover from insurers. Again, the exact scope of the benefit to brokers would depend on which, and how many, DMFs cease operating. It would depend on the risk products these DMFs provide and the ease with which a DMF member can access an insurance product to cover the risk previously covered by the DMF. DMFs argue that they cover risks that Australian insurers choose not to insure.

Regulators - APRA/ASIC

5.54 There would be no direct benefit to APRA or ASIC under this option.

Costs

DMFs

5.55 Under this option, DMFs would be subject to the same prudential, reporting and licensing requirements as Australian general insurers. This would eliminate the significant benefits that DMFs obtained from not having to comply with these requirements, in particular the minimum capital requirements, and from not incurring state insurance taxes on products they sold (although DMFs do incur taxes on the top up and drop down insurance products they buy).

5.56 This option would impose significant costs on DMFs doing business. In particular, DMFs would be required to comply with the APRA's minimum capital requirements for insurers (currently $5 million). DMFs unable to produce a fund of $5 million or to restructure so as to be able to offer contractual cover would cease operating.

5.57 In addition, DMFs would have to apply to APRA to become Australian authorised general insurers. The APRA application fee for a licence for general insurers is currently $68,200 (including GST).

5.58 There would also be the cost to the DMF of ongoing supervision. The current levy arrangements provide the best estimate of ongoing levies. The following excerpt from the Financial Sector Levies Discussion Paper provides a basis for the estimate.

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

DMF members

5.60 As a result of the capital requirements alone, it is likely that a number of DMFs would be unable to become authorised Australian general insurers and would instead exit the market. This would reduce the number of risk management tools available for Australians to choose between. The impact on DMF members would depend on how difficult it is for them to obtain replacement cover from the insurance market and how readily they can afford the additional premiums likely to be charged by the insurer. For many DMF members the cost is likely to be significant, as they have found it difficult to obtain insurance from traditional insurers, either because the risks they seek to insure do not fit neatly within the standard insurance products offered by insurers or because the cost of coverage is beyond what they can afford to pay.

5.61 DMF members may be unable to get insurance for some risks and may have to pay more to insure other risks, obtaining a less tailored product in the process.

5.62 For other DMF members the costs may be minimal, although there is likely to be an increase in the premiums that they are charged, due to taxes being levied on the entire risk and not just on the top up or drop down insurance policies that a DMF may take out to cover its risk products. Some DMF members may have risks for which it is relatively easy to find replacement cover from an insurer. For example, cover for a large business seeking property cover for an ordinary building is likely to be readily available in the Australian insurance market.

5.63 DMF members, if they become insureds, are also likely to be more greatly impacted by the Australian general insurance market cycle. At the moment, with a softening insurance market, they may be able to obtain insurance cover. As the cycle moves and the market hardens, they may find it more expensive or more difficult to obtain or renew cover. Anecdotal evidence suggests that a number of DMFs were set up after the collapse of HIH and UMP, at a time when the insurance market had hardened, precisely because their members could not obtain coverage from insurers either at all or at a price they were willing to pay.

Insurers

5.64 Insurers would also be under some pressure to provide cover at affordable prices for former DMF members whose DMF no longer covers their risk. This is particularly the case with community groups that had great difficulty in obtaining public liability cover when the insurance market hardened in 2001. Although a moderate cost for insurers, there could be reputational damage to the industry if former DMF members are unable to obtain replacement risk cover.

5.65 In addition, DMF members would have less incentive to minimise or take responsibility for their risks where they transfer that risk to an insurer. DMFs are funded by members who often have a common association and thus are likely to exert pressure on other members to minimise their risk. In contrast, there is little or no 'peer pressure' or risk management skill transfer between the different policyholders of an insurer (although, the number and amount of claims may affect the insurance premiums that a DMF member will pay in the future).

Regulators - APRA/ASIC

5.66 For APRA there would be the additional costs of granting more insurance licences. For APRA and ASIC there would be additional monitoring and enforcement costs associated with extending prudential regulation to these entities.

5.67 However, APRA is mainly funded through industry levies and licence fees, therefore any increased costs for APRA are likely to flow through to DMFs through levies. The exact estimate of these costs would depend on the number of DMFs that become insurers.

5.68 ASIC would have a minor cost saving because it would not have to issue licences to DMFs that were APRA-regulated and had only wholesale clients or monitor compliance with licensing requirements for these DMFs.

Option 2

Option 2: Potts review - no contingent risk

Benefits

DMFs

5.69 Anecdotal evidence suggests that a large number of DMFs would have no contingent risk and would be able to continue to operate in Australia. This option would provide a substantial benefit to DMF members and the Australian community, as DMFs would continue to provide an alternative risk management tool for DMF members. This option would also allow DMF members, who have been unable to obtain traditional insurance, to continue to transfer their risk to another entity, in this case the DMF.

DMF members

5.70 DMF members and third party beneficiaries would also have the significant benefit that there would be no contingent risk to them. If the DMF had insufficient funds to cover a claim, the DMF's top up or drop down insurance policies would cover the claim.

5.71 In addition, DMF members would have certainty as to the premium payable to cover their risk. The DMF would not be able to place a call on its DMF members.

Insurers

5.72 A number of DMFs may be unable to restructure or obtain insurance policies to cover some or all of their risks. As a result, these DMFs would have to cease operations. This could result in a moderate benefit to insurers in that they could potentially obtain more business from DMF members whose DMF ceased operation.

5.73 Finally, insurers would also have the substantial benefit that all DMFs remaining would need to insure the risks they cover for their members, so as to satisfy the no contingent risk condition.

5.74 Brokers, too, would obtain a moderate benefit under this option. A number of the DMFs, particularly those with difficult to place risks, may seek assistance in finding insurance to cover the risk above the DMF fund.

5.75 In addition, former DMF members, whose DMF has ceased operations, may also seek assistance from brokers in placing their risks and in obtaining the best insurance cover.

Regulators - APRA/ASIC

5.76 There would be no additional benefits to APRA or ASIC from this option.

Costs

DMFs

5.77 This option would impose significant costs on some DMFs. Some DMFs would not be able to obtain insurance cover for some or all of the risk products they offer their members. As these DMFs would retain some contingent risk, these DMFs would have to become insurers, cease operating or sever the lines of business for which they cannot obtain insurance cover.

DMF members

5.78 This option would result in a significant cost to some DMFs members, who may not be able to obtain insurance cover for their risks and will have to self insure. As a result, in the event that there is a claim for that risk they would have to bear that claim themselves. Depending on the size of the claim and how they are organised, this would see them potentially being liable for the claim or their business ceasing operations because the business has insufficient assets to meet the claim.

5.79 In addition, DMF members have the substantial cost of also losing an alternative risk management tool, potentially making them even more reliant on insurance and insurers and more susceptible to the insurance cycle. They would also have to pay in most cases a higher premium for their risk cover, as insurance taxes will be added to the pure risk insurance premiums.

5.80 The exact impact of applying this sort of regulation is not known as it is not clear exactly how many DMFs operate in Australia, the precise covers they offer, how many members they have or what is the scope of their activities. The decision to cease operating or to cease providing a particular risk cover would be made by the individual DMF based on its financial situation, the views of its members and the difficulty it had in obtaining insurance to cover its risk product. As a result, it is not possible at this stage to predict with any certainty what a particular DMFs would do or what would happen to the availability of particular lines of business.

5.81 Even those DMF members who remain part of an operating DMF are likely to have somewhat higher contributions. DMFs would have the additional administrative costs of providing financial statements and coverage details to APRA (so that APRA can determine they retain no contingent risk) and pass on the additional costs of obtaining top up and drop down insurance to cover the risks in the DMF fund. While, it is not anticipated that these administration costs would be significant, the cost of the additional insurance could be moderate. The exact costs to each DMF member would vary depending on how many members there are in the DMF, its lines of business and the complexity of its financial affairs.

5.82 It is not anticipated that the DMF's provision of information to APRA is likely to add significant costs to most DMF members.

5.83 Finally, this option does not strengthen the consumer protection provisions that would apply to potential DMF members determining whether or not to cover their risk through a DMF. The current arrangements outlined above under the policy objective would continue to apply. As noted, there are a number of DMF members who, although they are wholesale clients and therefore are not required to be given a PDS, nonetheless may not have the expertise to obtain information about the characteristics of the product they are considering purchasing.

Insurers

5.84 Insurers would be under some pressure to provide insurance policies to cover the DMF risk cover, given that the consequence of the DMF being unable to obtain cover is that it must cease to write that line of business.

5.85 The insurers would also face the same costs as outlined under option 1 where a DMF stops covering a member's risk and the member seeks to replace their DMF risk cover with insurance cover.

5.86 Although these are a minor cost for insurers, there could be reputational damage to the industry if former DMF members are unable to obtain replacement risk cover.

Regulators - APRA/ASIC

5.87 This approach is likely to result in significant costs for APRA, in the form of greater complexity and uncertainty, as APRA would have to establish, monitor and enforce a separate prudential regulatory regime applying only to DMFs. In particular, APRA is concerned that it is likely to be held responsible if a DMF collapses, as it developed the regime. This has significant reputational costs for APRA and significant costs for Australia's reputation as a well regulated insurance market.

5.88 APRA has estimated the costs of establishing a separate prudential regulatory regime at $500,000 to $1 million. This is, as noted earlier, a high level estimate.

5.89 APRA has no basis for estimating the cost of authorisation without considering in more detail the separate prudential regulation regime. It is suggested that the current general insurance licence fees provide an estimate of these costs in the absence of better information.

5.90 Similarly, APRA has no basis for estimating the on-going costs of monitoring, supervising and enforcing this new prudential regime without determining what monitoring, supervising and enforcing may entail. The current general insurance levies detailed above provide an estimate of these costs in the absence of better information.

5.91 The Government too is concerned with how it would define contingent risk and apply the test in a meaningful way to allow at least some DMFs to continue to operate in the Australian market. It would take time to determine what constituted no contingent risk.

5.92 In addition, it is unlikely that any concept developed will fully cover the range of activities that the Government is seeking to capture. This would require the Government to review the initial interpretation of contingent risk and to modify that definition. These changes would create uncertainty in the risk management market.

5.93 Moreover, given that the Potts review found that DMFs only account for 0.5 per cent of the Australian general insurance market, the Government may be seen to be overregulating DMFs, particularly in light of the Banks Taskforce report and the 'regulate first, ask questions later' culture identified in that report.

Option 3

Option 3: No prudential regulation but collect information and strengthen consumer protection and review in three years time the need for prudential regulation

Benefits

DMFs

5.94 This option would have the significant advantage of being proportionate, in that it seeks to address the critical concern of consumer protection in a targeted way, addressed specially at the provisions most directly created to enhance consumer protection, that is the disclosure requirements in the Corporations Act, while at the same time not imposing a form of prudential regulation on a group of entities, where there is insufficient information currently available to understand the extent and nature of their presence in the market and the risks they pose.

DMF members

5.95 This approach ensures substantial benefit to DMF members as they continue to have a range of risk management tools available to them, so that they can determine how to manage their risks. However, it also allows DMF members to make these risk management decisions based on disclosed information of the costs and benefits of using a DMF product over insurance to cover their risks.

Insurers

5.96 There would be no direct benefit for insurers from this option, although insurers may benefit from consumers being more well informed about the DMF product and as a result, choosing to have their risk covered by an insurance policy, rather than a DMF product.

Regulators - APRA/ASIC

5.97 APRA would collect information on DMF activities under this approach. For APRA, this is a significant benefit, in that it will be able to use this information to determine clearly the size, structure and lines of business of DMFs. They would also have the information necessary to assist Government in determining whether or not there is a need to prudentially regulate DMFs.

5.98 ASIC, too, would benefit. Requiring all DMF members to be given information on the key characteristics of the DMF product before they decide to cover their risks using the DMF product may reduce complaints from DMF members who did not fully understand the product they were obtaining. Because of the way complaints are made to ASIC and then recorded by ASIC, it is not clear how many complaints ASIC has received against DMFs. As a result, it is unclear how significant this benefit would be to ASIC.

5.99 The Government would also be seen to be taking a targeted approach and obtaining the necessary information to determine where or not there are prudential reasons to impose significant and costly regulatory requirements on business. This approach would have a significant benefit to the Government, in that it is in keeping with the Government's response to the Banks Taskforce. Moreover, by collecting information on DMFs, Government may also benefit by getting an early indication of gaps in the insurance market and signs when the insurance market is beginning to harden.

Costs

DMFs

5.100 DMFs would have slightly higher administration costs from this option as the DMF would have to provide APRA with information on its activities and its members with information on the key characteristics of the DMF product they are purchasing. At the moment they only need to provide this information to their retail clients.

5.101 It is not possible to calculate exactly what these additional costs will be because the costs will vary depending on the number of its members, whether these members are wholesale clients not currently receiving this information, the lines of business of the DMF and the complexity of its financial situation. It is likely that this amount will be very small as it would be spread across all the DMF members. In fact, anecdotal evidence suggests that those DMFs with both retail and wholesale clients will face no additional cost as they already provide wholesale clients with PDSs.

5.102 The DMFs that experience the highest administration costs are those DMFs that have only wholesale clients and presumably are not providing these clients with a PDS. However anecdotal evidence suggests that there are very few DMFs that fit into this category and as noted above the cost of printing and providing a information on the key characteristics of the product to members is likely to be very small, when spread across all of a DMFs' members.

5.103 Anecdotal evidence also suggests that the cost to DMFs of collecting the information APRA would require is likely to be comparatively small. A number of DMFs are already collecting information on the lines of business they write, the premiums they receive, the claims they pay out and the insurance premiums they pay for their own risk management purposes. As a result, it is unlikely to impose a significant cost on DMFs to pass this information to APRA. There is unlikely to be a significant increase in the administration cost on members.

5.104 DMFs are also required to provide annually to ASIC copies of their financial statements as a condition of their AFSL. Passing that information to APRA is unlikely to result in significant costs to the DMF and hence to its members.

DMF members

5.105 As noted above, it is not possible to calculate exactly what the costs of this option would be, but it is likely to be very small, as it would be spread across all DMF members.

Insurers

5.106 There would be no direct costs to insurers from this option.

Government regulators - APRA/ASIC

5.107 APRA would require additional resources to undertake the collection of information on DMFs. They estimate they would require $200,000 to $400,000 to establish the collection of information. Again, this is a high level estimate.

5.108 The ongoing cost per entity per receipt of information is likely to be $1,500 to $2,000. APRA developed these figures based on some work done in relation to superannuation licensing and so is reasonably confident with their robustness.

5.109 For those DMFs that provide professional indemnity and public liability cover there would also be the NCPD levy as detailed under Option 1 above.

Option 4

Option 4: No regulation

Benefits

DMFs

5.110 This approach has the benefit of not creating any additional compliance costs or paperwork for the DMF. Moreover, it also ensures that DMFs would continue to offer alternative risk cover. DMFs would continue to have the benefit of not being prudentially regulated or subject to state insurance taxes, to the extent that they do not pay insurance taxes on the proportion of the members' premiums that is pooled in the DMFs' fund. They would not have to retain a minimum level of capital and will not be subject to the risk management, reinsurance, or assets in Australia prudential standards outlined above, which insurers argue allows DMFs to provide their products at lower prices and gives them a significant competitive advantage. In addition, DMFs would not be required to provide information to APRA and will not face that additional cost.

DMF members

5.111 This option has the benefit that DMF members would have DMF products as an alternative risk management tool. In addition, DMF members would not be faced with the costs of the DMF providing information to APRA.

Insurers

5.112 There would be no direct benefit for insurers from this option.

Regulators - APRA/ASIC

5.113 This approach would not create additional compliance costs or paperwork on the regulators.

Costs

DMFs

5.114 This option has no cost for DMFs.

DMF members

5.115 This approach potentially imposes a cost on DMF members. Consumer protection provisions that protect potential DMF members are not strengthened, so it is not certain how well informed these potential members are and whether they understand the consequences that flow from choosing a DMF product over an insurance product. As a result, they may not have considered the financial implications to themselves if they are required to meet a claim and the DMF exercises its discretion to refuse the claim or there is a call on members.

Insurers

5.116 Insurers would also have the significant costs of having to compete with DMFs.

Regulators - APRA/ASIC

5.117 This approach also imposes a potentially significant cost on APRA, APRA may be concerned about leaving DMFs unregulated, particularly in the event that one of the DMFs collapses. In particular, APRA has made the point that Australian policyholders are unlikely to understand the distinction between a DMF product and an insurance product, in the event that a DMF does not pay out on a claim where the member expects it to or where the DMF collapses.

5.118 Under the current approach, there is a limited understanding of what DMFs must disclose to their retail members and there is less information required to be disclosed to wholesale members before they agree to purchase the product. As a result, ASIC cannot be certain that the members have fully understood the characteristics of the product they are purchasing. This may result in complaints to ASIC against the DMF which they will have to spend resources investigating.

5.119 In addition, without gathering information to understand the DMFs' role in the market, the Government also has the significant cost, under this approach, that it can not determine whether it should be concerned about the possible long term impacts of DMFs on the viability of the general insurance market in Australia. In particular, it cannot measure their effects on lines of business where Australian insureds have traditionally had difficulty obtaining insurance or determine whether any market gaps may be developing.

Consultation

5.120 The Government has undertaken a public inquiry into the regulation of DMFs and their role in the general insurance industry. It has also released a Treasury discussion paper and had continual consultation with key stakeholders over the last three years.

5.121 In 2003, the Government undertook the Potts review. The Potts review sought submission from the public on the extent and nature of DMF operations in Australia and their contributions to overall risk capacity. The Potts review received 19 submissions from a range of stakeholders including DMFs, Australian authorised general insurers, brokers and agents, industry associations, state governments and the regulators, ASIC and APRA. In response to comments in these submissions, the Potts review developed its key recommendations, which were accepted by the Government in May 2004.

5.122 In December 2005, Treasury released its public discussion paper seeking comments from all interested stakeholders on the implementation of the Potts review recommendations. It received 28 submissions from a range of stakeholders, including Australian insurers, DMFs, brokers, industry associations, the regulators, ASIC and APRA and a number of state governments.

5.123 Throughout this period, Treasury has also consulted with interested stakeholders. It has held a number of meetings with DMFs, insurers, brokers and both regulators to better understand DMFs and their role and regulation, and also to determine how to implement the Potts review recommendations.

5.124 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.

5.125 Insurers believe that DMFs should either be required to become authorised general insurers or be required to abide by the same regulatory requirements as insurers; that is, they should be required to comply with APRA prudential standards, the Insurance Act, Corporations Act and the Insurance Contracts Act. They want to ensure a level playing field and protect Australian policyholders and third party beneficiaries.

5.126 Brokers believe that DMFs should either be captured under the 'carrying on insurance business in Australia' definition in the Insurance Act and have to comply with that Act, or that their activity should be regulated through the financial intermediaries that provide their products and that they should be subject to increased disclosure requirements but not prudentially regulated.

5.127 DMFs do not believe that they should be regulated by APRA, either because of the structure of their business (that is they are a corporation limited by guarantee and as such they should be regulated by ASIC) or because they do not have any contingent risk because they have insurance policies to cover their risk cover beyond the money in the fund.

5.128 All stakeholders however do agree that it would be helpful to collect information on the activities of DMFs and their role in risk management market in Australia.

5.129 The views of these stakeholders have been taken into consideration in determining the options contained in this RIS. In essence, the options in this RIS were developed from the range of options suggested by stakeholders. These options were examined taking into consideration the key concerns raised by these stakeholders - competitive neutrality, the protection of DMF members and third party beneficiaries, the range of risk management tools available to provide capacity in the Australian risk management market and the potential broader systemic risk that DMFs pose to the risk management market, the financial system and other key markets in Australia.

Conclusion and recommended option

5.130 At the moment there is insufficient information to determine the role and size of DMFs operating in the market nor the type of prudential regulation that would be appropriate if they were to be licensed. There is no evidence that the collapse of a DMF would result in any broader systemic risk to the financial system and other markets in Australia. As a result, there is insufficient evidence to justify the prudential regulation of DMFs (either full prudential regulation [option 1] or partial regulation, by only allowing DMFs with no contingent risk to continue to operate [option 2]).

5.131 However, it is important to collect information on DMFs so that the Government can determine whether DMFs pose any greater risk to their members or the broader risk management market, financial system and other key markets in Australia. In the meantime, it is also prudent to ensure that those who use a DMF product to cover their risks have information available to them to allow them to weigh up the costs and benefits of using a DMF product over self insuring or taking out an insurance policy. As a result, the preferred approach is option 3. This does not involve prudential regulation at this stage, but would instead strengthen consumer protection, collect information on DMFs and review these arrangements and the need for prudential regulation within three years after the commencement of these arrangements.

5.132 This option rests on the assumption that full prudential regulation of DMFs is likely to result in DMFs exiting the market, reducing the risk management tools available to Australians and increasing the costs of risk transfer for those Australians that cannot get insurance to cover their risks.

5.133 Finally, it also rests on the assumption that, while DMFs account for a very small percentage of the Australian risk management market, they fill market gaps or provide products that may be more suitable for their clients than conventional insurance contracts.

5.134 This option balances the need to ensure that Australians can access a range of risk management products, while at the same time protecting DMF members, by ensuring that they have information about the product they are purchasing. In addition, it also provides for a review of the need for prudential regulation within three years after the commencement of the provisions and once the regulators have sufficient information to identify the role and markets of DMFs.

Implementation and review

5.135 It is proposed that option 3 will be implemented through legislative amendments to the FSCODA, Corporations Act and the Corporations Regulations.

5.136 The FSCODA will be amended so that it applies to DMFs. APRA, using its powers under the Act, will collect information on the risks DMFs are covering, the volume of business and any other information (for example, information on their structure) that the Government will require in order to determine whether there is a need to prudentially regulate DMFs. APRA will collate this information and it may be published, subject to confidentiality considerations. Limiting the information collected and collecting it only twice a year will reduce the compliance costs and paper burden on DMFs.

5.137 Information will also be collected from Australian financial service licence holders who promote or develop DMFs through an amendment to the Corporations Regulations.

5.138 Consumer protection provisions will be strengthened by inserting a regulation into the Corporations Regulations that specifies the information that a DMF must provide to its members before they join the fund, namely the mutual rights and obligations that flow from becoming a member of a DMF, including whether and to what extent they will be subject to a call, the discretionary nature of the product they are purchasing and how the rules governing their membership can be altered. This protection will cover both retail and wholesale clients of a DMF. The exact form that this regulation will take will be developed by ASIC and Treasury in consultation with industry. The intention is not to prescribe a set of words that must be used in the regulation, but rather to specify what the key characteristics of the DMFs' product are.

5.139 This approach is flexible, in that these items represent the minimum information that DMFs must disclose. The individual DMF and ASIC can determine whether there any other items that a particular DMF should disclose.

5.140 Finally, under this option the Government will undertake a review within three years of implementing these arrangements to determine whether or not DMFs should be prudentially regulated and, if so, how. Moreover, information will provide Government with information on the place DMFs occupy in the Australian risk management market in particular lines of business, to help it make this decision.

Discretionary Mutual Funds Quickscan report

What is the problem you wish to address?

Anecdotal evidence suggests that purchasers of DMFs products may not be aware that they are not purchasing insurance. In addition, as DMF products are not insurance, DMFs are not subject to the prudential requirements in the Insurance Act. As a result, some argue that DMFs have a greater risk of collapsing or of being forced to exercise their discretion against paying claims because they have insufficient funds. However, Government does not have sufficient information to determine what role DMFs play in the Australian risk market and whether they pose a greater risk of collapsing because they are not prudentially regulated.

What is the objective of the policy?

The objective of Government action is to ensure that Australians have a range of risk management tools available to them and information about the characteristics of the options they are considering, so that they are in a position to make an informed decision on how to best manage their own risks.

At the same time, the Government is seeking to maintain not only contestability, competitiveness and innovation in the insurance sector and community confidence in the Australian general insurance market, but also Australia's reputation as a sound, well-regulated insurance market. To do this, Government must obtain more information on DMFs.

Businesses Affected:

unknown due to the lack of information. Anecdotal evidence suggests between 50-100.

Supporting evidence for the following options:

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

Level of certainty for the following options:

Low

Option 1: Full prudential regulation

Under this option, DMFs would be required to become Australian authorised general insurers under the Insurance Act in order to continue operating. As an Australian authorised general insurer, they would be subject to the consumer protection provisions that apply to general insurers under the Corporations Act and Insurance Contracts Act 1984 and APRA would collect information from them under FSCODA.

Option 2: Potts Review - no contingent risk

Under this option, the Government would implement the Potts review recommendations that required discretionary mutual cover to be offered only as a contract of insurance under the Insurance Act, except where APRA considered that the DMF had no contingent risk that would need to be met by additional undefined member contributions. (Such risks would fall on a general insurer providing top up and drop down cover.) APRA would also be required to collect information on business written by DMFs under the exemption.

Option 3: No Prudential Regulation, but collect information, strengthen consumer protection and review within three years

Under this option, DMFs would not be prudentially regulated at this stage. However, DMFs would continue to be subject to the consumer protection provisions of the Corporations Act and the provisions that apply to DMFs' retail clients would be strengthened and extended to DMFs' wholesale clients. DMFs would also become subject to FSCODA. Information would also be collected from AFSL holders who promote or develop DMFs through an amendment to the Corporations Act. The Government would review these arrangements within three years of their implementation to determine whether or not to prudentially regulate DMFs.

Option 4: Status quo - no prudential regulation

Under this option, the current arrangements regarding DMFs would continue. DMFs would not be prudentially regulated. ASIC would continue to regulate DMFs under the Corporations Act as an AFSL holder and they would be required to comply with the Corporations Act disclosure requirements for retail clients. For example, they are required to disclose key characteristics in their PDS to retail clients.