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Focus: Insurance & Reinsurance – October 2007

DOFIs: three limbs provide possible exemptions

In brief: On 20 September 2007, the Commonwealth Treasury released a discussion paper containing its proposed exemptions from new legislation that affects all direct offshore foreign insurers (DOFIs) carrying on insurance business in Australia.1 The new legislation received Assent on 24 September 2007. Partners John Morgan (view CV) and Dean Carrigan (view CV) and Senior Associate Mark Lindfield explain the key proposals in the discussion paper.

How does it affect you?

  • The Treasury has proposed a three-limbed test for exemption from the new requirements that will require DOFIs carrying on insurance business in Australia to be authorised from 1 July 2008.
  • High-value insureds with significant revenue, income or employees will be able to place insurance with DOFIs without triggering the authorisation requirements under the Insurance Act 1973. Other insureds may be able to rely on the exemption for some specialist classes of insurance. Anyone else wanting to rely on the exemption will need to satisfy a range of criteria to prove that the risk they are seeking to insure is unique. Whether that assessment is performed by an insurance broker or a regulator is not yet clear.
  • Submissions on Treasury's proposals have been invited and are due by 31 October 2007.

Background

The Insurance Act 1973 (the Act) is being amended to make clear that carrying on insurance business in Australia, whether directly or indirectly through the actions of another (for example, an agent or broker), will trigger the requirement to be authorised under the Act. This means that the Act will apply to all DOFIs carrying on business in Australia, regardless of whether they are structured as captives or operate through local Australian branches or subsidiaries.

The amending legislation was introduced into Parliament on 21 June 2007, and received Assent on 24 September 2007.2 (For more information on the legislation, see AAR Focus: Insurance & Reinsurance – May 2007 and AAR Client Update: Insurance & Reinsurance – June 2007.

The amendments to the Act will take effect from 1 July 2008. From that date, a DOFI that seeks to carry on insurance business in Australia will be required to be authorised by the Australian Prudential Regulation Authority (APRA) and comply with the prudential requirements imposed by the Act and by APRA. The legislation also prohibits a holder of an Australian financial services licence (AFSL) from dealing in a general insurance product that is not issued by an authorised insurer, Lloyd's or an exempted DOFI.

However, when the amending legislation was introduced, the Federal Government announced that a limited exemption would apply where cover could not be obtained from insurers authorised under the Act. For example, this might occur in circumstances where there was a specialised risk involved or because of the small size of the local market compared with the global market.

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Proposed exemptions

The Treasury proposes that there be three limbs to the limited exemption under the Act.

High-value insureds

Under this limb, DOFIs that insure Australia's largest businesses would be exempt from the requirement to be authorised under the Act. Those businesses are taken to be sophisticated risk managers and purchasers of insurance, whose complex risks might not be adequately covered if they could only obtain insurance from authorised insurers.
This exemption applies if the insured (or their intermediary) assesses that one or more of the following are true:

  1. the consolidated gross operating revenue for the financial year of the insured business (and any entities it controls) is $200 million or more;
  2. the consolidated gross assets at the end of the financial year of the insured business (and any entities it controls) is $200 million; or
  3. the insured business (and any entities it controls) has 300 or more employees at the end of the financial year.

This test would be applied when the insured purchases or renews insurance or materially alters the terms and conditions of an existing insurance contract.

This test is based on the current definition of a 'large proprietary company' contained in the Corporations Act 2001 (Cth). The Treasury favours this test because it is well understood by industry and would involve little additional cost to implement.

The Treasury also considered alternative tests based on the amount of premium spent by the insured business or based on the amount of insurance cover effected by the insured. However those tests were not preferred because of the potential that they could be manipulated in order to circumvent the new restrictions in the Act.

Atypical risks

Some insureds might not satisfy the first limb of the exemption but still warrant exemption because of the difficulty in obtaining particular types of insurance. Insurance covering such risks may only be available in Australia as part of a bundled contract of insurance. Alternatively, it might be available as a standalone policy from a DOFI but the small size of the Australian market may provide little incentive for the DOFI to seek authorisation under the Act.

The Treasury proposes that the regulations made under the Act will contain a list of atypical risks. If an insured or their intermediary assesses that a risk appears in that list, then they will be free to place that risk with a DOFI not authorised under the Act. The DOFI, however, would not avoid the authorisation requirement under the Act if it also carried on other insurance business in Australia.

The risks currently proposed to be listed in the regulations include malicious product tampering, commercial shipping hull, asbestos, nuclear, war and satellite cover, among others. The list of risks is proposed to remain unchanged for three years, after which it will be reviewed.

Customised exemption

Some insureds might not be entitled to benefit from the first two limbs of the exemption but still be unable to obtain insurance from authorised insurers in Australia because of the unique nature of their circumstances. For example, this may occur in circumstances where the insured has a poor claims history or where there is a significant rise in premiums. It may also occur if an important part of the insured's business activity is excluded from the terms and conditions of their insurance cover.

Whether a particular insured can take advantage of this limb of the exemption will require an assessment against a range of criteria that will be contained in the regulations. They are proposed to include factors such as the capacity of local insurers to provide the cover, the price and quality of cover, as well as a recognition of the importance of continuing existing relationships. The criteria are to be developed after further industry consultation.

As to who performs this assessment, the Treasury is considering whether a market-based or regulator-based assessment would be preferable. Under a market-based approach, an insurance broker acting on behalf of an insured and holding an AFSL would assess the availability of insurance for the insured in the local market.

However, the Treasury considers that there is a risk that the criteria may not be applied appropriately under a market-based approach and more insurance business may be written in Australia by DOFIs than is strictly necessary. Therefore, the Treasury has proposed an alternative approach under which a regulator would perform this assessment. It is not clear whether APRA or the Australian Securities and Investments Commission (ASIC) would perform this role – each has been suggested as a possibility in the discussion paper.

The first two limbs only apply to high-value insureds and specific classes of exempt business, so DOFIs will need to monitor on a case-by-case basis whether they need to be authorised by APRA.

In relying on the second or third limb of the exemption, if an intermediary holding an AFSL places an Australian insured risk with a DOFI, then the intermediary must give a notice to the insured that is based on the existing requirement to notify insureds of the consequences of doing business with DOFIs.3

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Comment

The Treasury has invited submissions in response to its proposals. Some questions that the proposals raise include:

Does the approach proposed under the first limb adequately define a 'high value insured'?

It remains unclear as to what types of entities will be able to take advantage of this limb, including companies, partnerships, individuals, joint ventures, trustees, associations and so on. Also, will this limb require that each insured under the policy meets the test? If not, what consequences does this have for unrelated parties insured under a single policy?

Are there any atypical insurance lines that need to be added to or removed from the list under the second limb?

Is it really the case that none of the risks referred to in the discussion paper can be underwritten in Australia on a standalone basis? The discussion paper infers that it is not suggesting that they are not available at all but that they may not be available on appropriate terms or at an acceptable price.

How will the self-assessment process be implemented under the first and second limbs?

Insurance brokers that hold AFSLs will need to consider whether their existing systems and processes will be adequate to enable them to maintain appropriate records of the self-assessment process. In particular, ASIC may be expected to exercise rights of audit and inspection in relation to those records to ensure that the self-assessment process is functioning appropriately.

Do APRA and ASIC have sufficient capacity and expertise to implement the third limb?

If the regulator-based assessment process is preferred by Treasury, then it raises the question of whether it would be more appropriate for APRA or ASIC to be responsible for that assessment. APRA is the prudential regulator of insurers but ASIC is the regulator of AFSL holders, including insurance intermediaries. APRA's knowledge of the general insurance industry suggests that it is the appropriate regulator. Whichever regulator is preferred, the timeliness of assessment process will be critical.

If applications for exemption under the third limb are assessed by a regulator, will those applications be transparent and made public?

Where an insured obtains the exemption under this limb, will it be open to its competitors to apply for an exemption on the same grounds? Will its competitors be able to provide corrective information to the regulator about the availability of insurance in the market, which may affect any exemption already granted?

Will all brokers be able to perform the self-assessments referred to in the proposals?

Larger brokers may have the resources and expertise to conduct the assessments contemplated in the proposals but this may be an issue for smaller brokers. There is also a question about the incentive for brokers to perform such assessments with due diligence in circumstances where the timeframes imposed by impending renewals may not be conducive to a comprehensive assessment.

What evidence will be required to establish that a risk cannot be placed locally?

The proposals suggest that it will not be necessary to establish that each risk absolutely cannot be insured with an authorised insurer but factors including price and terms will also be relevant. The more that subjective elements are taken into account, the more likely it would seem that an insured would be able to support a case for exemption.

What other issues not addressed in the discussion paper need to be considered?

The discussion paper does not consider the issue of offshore risks and whether there is any benefit in requiring an Australian entity to insure their overseas risks with an Australian authorised insurer. Also, what considerations will apply where an insured is required by overseas law to place insurance with an unauthorised DOFI? Presumably this would fall within the third exemption but the discussion paper does not refer to this scenario.

What transitional arrangements will apply?

There is no detail in the discussion paper of any proposed transitional arrangements. It will be important for industry to be able to identify in advance what arrangements will apply in relation to endorsements or variations that are made to existing insurance contracts after the commencement date of the proposals.

Submissions have been invited on these questions and others. The closing date for submissions is 31 October 2007.

It is also worth noting that, on 31 July 2007, APRA released a discussion paper in which it proposed to introduce some refinements to the prudential regulation of insurers authorised under the Act.4 This paper proposes to introduce five categories of insurer and to apply APRA's prudential standards to each category in a manner that is appropriate to insurers in that particular category. The categories not only to reflect the new prudential regulation of DOFIs carrying on insurance business in Australia but also provide a form of tailored prudential regulation for locally-incorporated insurers, subsidiaries of foreign insurers and captives. These proposed refinements are intended to commence with effect from 1 July 2008. Submissions on the APRA discussion paper closed on 28 September 2007.

Footnotes
  1. Regulation of Direct Offshore Foreign Insurers – Exemption Discussion Paper, 20 September 2007.
  2. Financial Sector Legislation (Discretionary Mutual Funds and Direct Offshore Foreign Insurers) Act 2007.
  3. Regulation 7.9.12 Corporations Regulations 2001.
  4. Discussion Paper: Refinements to the General Insurance Prudential Framework, 31 July 2007.

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