Concern about APRA capital requirements

Leading global consultancy Towers Watson has taken issue with some elements of the Australian Prudential Regulation Authority’s (APRA's) proposals that impose stricter capital requirements on life insurance companies.

In an analysis of the proposed APRA approach, Tower Watson expressed as one of its main concerns the approach to the so-called “risk free discount rate” and, in particular, the use of national government securities.

“Our main concern with the use of yields of national government securities, and in particular Australian government securities, is the potential for market distortions in times of economic stress,” the analysis said.

“In turbulent times, with increasing or volatile credit spread, companies could be expected to look to de-risk their investment holdings, seeking to increase holdings in the risk-free asset class,” it said. “At a time when credit spreads are deteriorating, the increased demand for the risk-free assets will push yields on the risk-free assets lower, leading to even higher credit spread.”

The Towers Watson analysis also pointed to other drawbacks attaching to the use of yields based on Australian government securities, including that it would not be possible to hedge interest rate risks effectively.

The company urged further debate on the issue based not only on considering the benefits or otherwise of the APRA proposal, but also on the relative advantages and disadvantages of alternative starting points such as swap rates, yields on semi-government instruments and yields on minimum cost replicating portfolios.