This Federal Budget confirmed the pre-announced changes to remove the inequitable tax treatment of deferred lifetime annuities and give them the same tax treatment as current income streams.

The government also announced a new pilot scheme to allow senior Australians to downsize their home without reducing their Age Pension if the home has been owned for at least 25 years. Amounts up to $200,000 can be deposited into a separate account which will be an exempt asset for up to 10 years.

In response Actuaries Institute CEO Melinda Howes said; “We were encouraged by the confirmation of more favourable tax treatment of deferred lifetime annuities, which will provide retirees with the ability to insure their longevity in a more cost effective way.

“The new announcement allowing the downsizing of a retiree’s home without reducing Age Pension is a sensible initiative which will assist the current generation of retirees who didn’t have compulsory super for their whole working lifetimes, and for many of whom the family home is their main retirement asset.

“Actuaries play a unique role in business and society through their ability to assess risks through long-term analyses, modelling and scenario planning,” she said.

One of the key risks identified by the Institute is ‘longevity risk’ – the risk of people outliving their retirement savings. In September 2012 the Institute released the white paper “Australia’s Longevity Tsunami, what should we do?”, which emphasised the need for retirement policy reform in the face of Australia’s steep and continuing rise in life expectancies.

Ms Howes said underestimating life expectancy will have major implications for retirement incomes policy, which must take into account individual financial security as well as the economy-wide costs of providing for an ageing population.

“There is an urgency of the situation we are facing – we don’t have years to reform the system – the current generation of workers need better retirement product solutions now. The current system and most people’s own planning do not take into account how long the current generation of Australian workers will live,” Ms Howes said.

“It was encouraging to see the budget remove one of the key roadblocks to developing better post-retirement products by changing the tax laws on deferred lifetime annuities (which are essentially longevity insurance). We look forward to continuing to work with policymakers to ensure the way is cleared for innovative products to be developed to assist our increasing number of retirees to manage their retirement risks.”

“While this move is encouraging, the government and financial services industry need to better educate consumers about the role deferred lifetime annuities, and indeed, other longevity / mortality pooled products, can play in securing an adequate retirement income in extreme old age. It’s all about how the product is presented to you – At the moment many Australians view annuities as expensive as they do not realise how long they will live.”

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“Continuing global financial market volatility and a spate of natural disasters in recent times, highlight the need for effective enterprise risk management,” said Melinda Howes, Institute of Actuaries CEO.

“In this context, we surveyed 250 actuaries and other professionals across Australia’s largest financial and commercial enterprises to see how our ERM practices compare globally and more importantly, what we can do to improve them.”

Australian financial institutions are generally risk averse – their risk appetite was rated “moderate” by more than half of the respondents (54%) with the next largest response (27%) rating it “somewhat low”.

Eighty one per cent of actuaries willing to compare Australia with other countries ranked Australian organisations as performing “above average” or “the middle of the pack” or “among the leaders in this field” for ERM practices and management of risk culture. Only 11% believe Australia lags the rest of the world.

Respondents highlighted the top three benefits of effective ERM implementation as: minimising losses to the organisation (75%); improving financial performance/maximising Return on Equity (64%); and managing expectations of customers, staff and investors (54%).

“Encouragingly, the survey showed most organisations (60%) believe they have an ERM program that is either “somewhat mature” – thoroughly communicated to staff and part of everyday discussions – or “moderately mature”, said Ms Howes. “Another 11% said their ERM program was “very mature”, that is, embedded and integrated in the business processes and culture of the organisation.”

However, while most respondents felt there was a commitment from the head of their organisation to effective ERM (84%), only 20% of that group thought it was a “very high” level of commitment.

Risk culture development
Despite the high reported levels of mature ERM programs in place, only 52% of organisations appear have an embedded, formalised risk culture communicated to staff, and only 37% of members surveyed said their organisation’s approach to building and fostering a risk culture is “good” or “very good”.

“The much lower proportion of organisations with an embedded, formalised risk culture compared to those with a mature ERM program reflects the challenge and long-term commitment required to change organisational culture,” Ms Howes said. “Embedding a risk culture in an organisation is the key to success.”

The survey showed the main barriers to developing a risk culture are: lack of commitment from leadership (51%), a poorly defined risk culture (46%), and poor communication to staff (37%).

Linked with those barriers, respondents were asked the most common failures of their organisation’s risk culture which included: ignorance of risk culture parameters and policies (49%), ignoring processes and reporting (43%) and poor governance practices (35%).

“Organisations should focus on eliminating barriers to developing a risk culture so ERM can be part of everyday decision making,” said Ms Howes.

Social and environmental factors

The majority of organisational ERM programs focus on operational risk factors (91%), followed by economic risk factors (77%) and strategic risk (71%) factors. Interestingly, fewer programs consider social (26%) or environmental (28%) factors.

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Commenting on its submission to the Natural Disaster Insurance Review (NDIR), Institute CEO Melinda Howes said, “While the Australian insurance market generally meets the needs of society, recent natural disasters demonstrate intervention in the market is necessary to assist consumers who are underinsured or not insured at all, particularly in the area of flood insurance.”

The Institute’s submission argues mitigation options aimed at protecting land and property from flood risks, such as revising building codes, planning rules, building dams and levies, and undertaking re-location and renovation of existing properties, are more likely to be cost-effective in the long term compared with the current approach of post-event funding of natural disaster-related losses.

“There are many pieces to the puzzle of natural disaster resilience and ideally insurance should be the last option.  To ensure insurance is affordable and accessible, it’s vital appropriate mitigation action is taken by all stakeholders, including all levels of government, consumers and businesses,” said Ms Howes.

The Institute recommends the creation of a national insurance pool until mitigation action eliminates or reduces the community flood risks to an acceptable level, which is expected to take 10 to15 years.  This pool could be funded by various options including taxpayer levies, a broad increase in premiums for all insureds or direct government funding. 

“We recommend a temporary national insurance pool to provide subsidies to high risk insured parties rather than the government providing direct subsidies without pooling, and we recommend the subsidies be contingent on implementing risk mitigation measures,” explained Ms Howes. “Without this, risky behaviour such as continued building in high risk areas might be inadvertently encouraged.”

The Institute recommends a national insurance pool cover all “water off the ground” related loss to avoid confusion, and cover loss from both flood and actions of the sea, with a possible extension to other natural disaster risks if insurance affordability or accessibility is an issue.

In addition to a national insurance pool, the Institute recommends measures to better inform stakeholders, primarily through government sponsored national flood mapping to be made widely accessible to all stakeholders including all levels of government, businesses and consumers, as well as consumer information presented in a form which facilitates prudent behaviour.

“We strongly encourage the development of a single national standard for flood mapping in this country to support better risk mitigation efforts, risk pricing, risk exposure management and risk transfer mechanisms.  Stakeholders should contribute to the cost of these maps, depending on use,” said Ms Howes.

The Institute also suggests the government investigate purchase and/or issuing of catastrophe bonds or similar financial instruments to fund natural disaster-related losses, which could operate so that private investors purchase fixed rate government bonds with a redemption value that reduces on the occurrence of a natural disaster event.

“While the recent natural disasters have resulted in tragic economic and personal loss to people and businesses around Australia, we now have an opportunity to create a sustainable national solution for flood and natural disaster resilience which ensures we are better equipped for the future,” concluded Ms Howes.

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The Natural Disaster Insurance Survey, to be released at the Institute of Actuaries Biennial Convention in Sydney today, surveyed Institute members across general and life insurance, banking, superannuation and wealth management, about future insurance industry and government involvement in a national solution for natural disasters.

“Members of the actuarial profession work across risk management, insurance and public policy, so are well placed to provide valuable insights into viable options for a nation-wide approach to natural disaster management,” said Peter McCarthy, Chair of the Institute’s General Insurance Practice Committee.

“Our Institute survey showed that nearly 55% of actuaries believed there was a role for a national insurer to provide a level of disaster coverage while 58% said there was a role for a national reinsurer,” said Mr McCarthy.

However, only one third of respondents said flood insurance should be made compulsory.

“The survey finding against making flood insurance compulsory (55%), with over 11% unsure, recognises that the end result is likely to be low risk households subsidising high risk households, which may discourage individual responsibility,” Mr McCarthy said.

“The overwhelming majority of the profession supports the existing risk-rated model for property insurance, with more than 73% of respondents rejecting community rating for flood insurance and 53% rejecting premiums being subsidised for high risk policyholders,” he said.

Another 54% thought government compensation payouts should be capped for those without insurance to discourage rebuilding in high risk areas while 95% said the government should introduce requirements to restrict new developments/properties in flood prone areas or introduce building codes to mitigate risk of flood on new properties.

In the context of how the insurance industry should respond to increased risk from natural disasters, 75% of respondents think insurance companies should offer incentives for mitigation measures, 70% think there should be more investment in data collection (eg, flood mapping), while more than half (57%) believe there should be uniform definitions for cover.

The survey findings will feed into the Institute’s policy making process.

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“Reform of the system for disability care and support is essential from a social policy and long-term economic perspective, and it is important that the proposed National Disability Insurance Scheme is developed and implemented on a sustainable basis,” said Julie Evans, Convenor of the Disability Taskforce of the Institute of Actuaries of Australia. The taskforce will examine the Productivity Commission’s draft report.

“The Institute notes the draft report’s focus on the need to provide certainty for people with a significant disability and their carers. A sustainable scheme has features that recognise the financial risks involved where long-term commitments are made. Identification and effective management of these risks will provide certainty to those who will receive long-term care and support from the NDIS in the years to come,” Ms Evans said.

“Strong scheme governance and financial management, including comprehensive monitoring, are essential for sustainability. The draft report’s proposal to use a commercial insurance based approach provides a good platform for this,” she said.

Salient lessons can be learned from the experience of current state-based accident compensation schemes and other similar organisations operating internationally.

“Lessons from existing accident compensation schemes include the social value that can result from early intervention and participation in the workforce, and that an individual approach to case management is important to optimise long-term outcomes. The value of consistent and disciplined management has also been demonstrated,” Ms Evans said.

In its submission to the Productivity Commission’s enquiry, the Institute set out principles covering financial aspects which need to underpin provision of disability care and support services. These principles were developed based on the work of the many actuaries who provide advice on the financial sustainability of insurance schemes which provide support for those with disability through Workers Compensation, Motor Vehicle Accident Compensation, Medical Indemnity Insurance, Life Insurance or Superannuation.

“As part of the actuarial profession’s contribution to Australia’s public policy development, the Institute looks forward to providing further input to the Productivity Commission and public policymakers on the Productivity Commission’s draft report, as the Commission develops the formal recommendations for its final report,” Ms Evans said.

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“We urge the Government to prioritise Budget policies aimed at managing Australia’s ageing population, including flexible ‘new generation’ annuities which protect against the risk of outliving your retirement savings and the market risk of losing superannuation capital in retirement,” said Melinda Howes, Institute CEO. She said while Australians had long been warned about the risk of outliving their savings, the Global Financial Crisis had underlined an additional market risk.

The Institute believes new generation annuities should seek to emulate some features of popular account-based products like allocated pensions. While allocated pensions are market-linked and provide no income guarantee, they provide retirees with access to their capital, payment flexibility and potential benefits from a rising share market.

“Account-based products give retirees more control over their income and assets, allowing them to adjust to changing circumstances and to respond to unexpected or ‘lumpy’ expenses’,” Ms Howes said. “However, while retirees enjoyed solid investment returns in these products for the last 20 years or so, the GFC saw many experience significant capital erosion, which they will not be able to recover.”

“Retirees should be able to purchase a product which offers them protection against the two major risks they face, market risk and longevity risk, and they should be able to choose to be fully or partially protected from either or both of these risks, depending on their circumstances.” Lifetime annuities, which provide such guarantees today, are unpopular due to their inflexibility and perceived low returns.

In order for innovation to occur in the annuities market, the Institute believes that:

• Superannuation Industry Supervision Act Regulation 106 must be revised as it unnecessarily prescriptive;
• the unfavourable treatment of annuities under aged care and Centrelink rules must be reversed;
• annuities and deferred annuities should be able to be issued as a component of an account-based pension; and
• the tax rules on deferred annuities should be changed so that, if taken out in the drawdown phase, the product is regarded as a pension (rather than a nonpension) for tax purposes and that there should be be a clear, regulatory regime for variable annuity style products.

In its submission, the Institute notes the superannuation market is still immature and that many people will reach retirement with a sum too small to annuitise (less than $100,000).

“For people with small retirement sums, a deferred annuity may act to deliver additional insurance, through additional income in extreme old age. Or, retirees could be encouraged to live off the superannuation they do have, but defer taking the government aged pension for as long as possible. Such people could be rewarded with a higher age pension, of up to double the standard age pension for a 10-year deferral,” Ms Howes said.

SUMMARY OF FEDERAL BUDGET RECOMMENDATIONS:

• Remove barriers to innovation in the annuity product market, such as the unnecessarily prescriptive SIS Regulations that limit the design of these annuities, and the unfavourable treatment of annuities under aged care and social security rules.
• Allow the age pension to be deferred, so that if someone eligible for the Age Pension keeps working for up to 10 years after Age Pension age, their Government Age Pension increases. This means individuals can fund the first part of their retirement for a known period and rely on a higher Age Pension to manage their longevity risk.
• Encourage workforce participation by removing earned income from the Age Pension means test so retirees are not penalised for working if and when they can.

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The Institute, whose member actuaries work for insurers rating risks and setting premiums, notes that the lack of adequate insurance coverage for floods and/or its prohibitive cost, are key issues which must be addressed in any national funding solution.

“One positive outcome of the Queensland events is that flood has finally become a serious subject of debate after many years of being ‘out of sight, out of mind’ or ‘too hard,” according to Peter McCarthy, chairman of the Institute’s General Insurance Practice Committee.

“While flooding and severe rain events have always been common in Australia, compared to say, cyclones or earthquakes, getting insurance can be very difficult or prohibitively expensive. Furthermore, a distinction is often drawn by insurers between flood types, such as riverine versus storm, which can elude consumers,” Mr McCarthy said.

“The issues with flood are that, unlike other disasters, the same properties flood again and again, many high risk areas are known by residents, business owners, governments and insurers, and the scale of damage is greater than for other disasters,” Mr McCarthy said. Flood premiums insurers must charge to provide full flood cover are also extremely expensive. As a simple illustration, a $500,000 property which floods every 30 years may require a premium for flood of up to tens of thousands of dollars.”

The Institute believes that any national solution for flood must begin with an agreed policy goal and an understanding that the issues are broader than insurance. “For example, is the objective to fully compensate everyone affected for their losses or to partially compensate a proportion of those affected?” Mr McCarthy said.

“There’s also a need to decide what property will be covered and to what limits. Will there be compulsory cover? Will private residence and commercial properties be covered? Will government infrastructure be covered?

Defining what ‘flood’ events are covered is also key, Mr McCarthy said.

“There are complexities regarding interaction of flood with other natural hazard covers. For example, flood damage which occurs when rain is still falling creates an overlap between ‘storm’ and ‘flood’ covers. Or, in the case of Cyclone Yasi, damage caused by wind is likely covered but damage from a river flooding caused by rain from a cyclone may not be covered and storm surge is normally not covered.”

A realistic assessment must also be made about whether it’s affordable to implement the solution long-term. The collection mechanism (tax, levy, or premium), level of compulsion to contribute and amount required to reinstate damaged assets, may also limit options.

“To manage affordability, options must address the level of cross-subsidies from owners of properties that are not in flood prone areas to owners of properties which are,” Mr McCarthy said.

And, to estimate costs and address issues associated with a funding solution, modelling of flood impacts is required, but the limitations of this must also be recognised, he said.

“Floods referred to as a ‘1-in-100 year’ or similar event may be more like 1-in-25 levels.  And, changes in land use (eg increased urbanisation leading to concrete covering land that was formerly grassland or forest) changes future flood impacts.”

It’s also important that a solution does not discourage research into flood prevention and mitigation, Mr McCarthy said. Changes may reduce the likelihood of flood damage, through changes to building codes or zoning, or reduce incidence or severity of damage through levees, dams or other structures.

Governance and oversight is also important and includes relevant legislation, public reporting and dispute resolution. This includes whose responsibility it will be to ensure property at risk is covered – whether this is individuals, government or both. Any funding solution should also address what relief should be provided to those with no insurance or those who are underinsured,” Mr McCarthy said.

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Bozenna Hinton, Institute President, said the Institute supports the concept of an identifiable risk reserve for superannuation funds held separately from member account balances. She said the minimum level for this should be set on a risk assessed basis consistent with other financial services industries.

“We are pleased that the Government will consider a risk based system for all APRA regulated super funds requiring them to hold financial resources against operational risk, as we recommended this in our submissions to the Cooper Review,” Ms Hinton said. “We note that the Government will consult with relevant stakeholders on whether such a system should require resources to be held in the form of trustee capital or an operational risk reserve in the fund.”

The Institute confirms that as part of this process, a Financial Condition Report for accumulation super funds should eventually become compulsory, but in the meantime should be considered best practice. Such a report would allow trustees to stress test a super fund under different market conditions.

Support for idea that super funds consider longevity risk but more work needed The Institute also supports the recommendation that both MySuper and choice super funds be explicitly required to consider longevity and inflation risk. However, Ms Hinton said more concrete measures were needed.

“As a next step, we encourage the Government to remove the roadblocks preventing innovation and product development in the post retirement product market including social security and tax barriers.

Development of new post retirement products will better equip Australians to protect themselves against their own longevity risk,” Ms Hinton said.

The Government has also indicated that while it does not support mandatory retirement forecasts for MySuper products, it will ask the Australian Securities and Investments Commission to continue working on developments in this area.

“The Institute strongly supports the idea of retirement forecasts being provided to super fund members so is disappointed about this outcome. However, we look forward to working with ASIC particularly in relation to the assumptions used for such forecasts and how the results could be presented,” Ms Hinton said.

“Similarly, we look forward to working with APRA and ASIC regarding the publication of superannuation data designed to improve transparency and comparability in relation to net investment performance fees and costs,” Ms Hinton said.

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APRA, Challenger Limited, Ernst & Young, the Institute of Actuaries of Australia, Suncorp Metway and Westpac Bank jointly sponsored the research project. The project, chaired by leading actuary Tony Coleman, considered the potential for market distortion or arbitrage due to current inconsistencies in standards, and the potential for systemic risk arising from the current frameworks.

The research was aligned with the current international agenda for proposed future regulation of banks and insurers. In a recent keynote speech on this subject, Adair Turner, Chair of the Financial Supervision Committee of the Financial Stability Board, noted the need for regulation to be “sufficiently consistent across sectors to guard against regulatory arbitrage” and for a “continually updated” regulatory understanding of the inter-connected nature of the financial system and systemic risks that may result.

“The aim of our research is to make a meaningful contribution to ongoing work aimed at better understanding differences in regulation between banks and insurers, while using the opportunity offered by the G20 process to identify situations where regulatory arbitrage, market distortion and systemic risk could arise,” said Tony Coleman. “In some instances, inconsistencies may result in a product provider choosing to manage a product from a part of a group where lower capital standards apply and therefore where a higher return on equity could be achieved,” he said.

The paper finds that materially different regulatory capital requirements currently exist in the area of term deposits and term certain annuities. In this case, both products provide a similar outcome for consumers (i.e. effectively an assured return of income and capital) but annuities have significantly higher capital requirements because they are provided by life insurers rather than banks. Higher capital requirements have the effect of lowering the overall return and relative attractiveness of term certain annuities. This outcome needs to be considered in the context of broader public policy.

In another instance, at a framework level, provisioning is treated differently between banks and insurers, despite conceptually seeking to achieve a similar purpose.

“The research also sought to recognise that any proposed regulatory reforms focused on greater consistency must also consider the inter-connected nature of the financial system and potential for systemic risks,” Mr Coleman said.

Ernst & Young noted that achieving consistency between sectors is not straightforward. In particular, APRA is constrained by history and by international regulatory developments that do not necessarily have the same objectives. However, APRA’s proposed conglomerate reforms provide an opportunity to achieve a higher level of consistency where appropriate.

The research also found that banking and insurance sectors would benefit from increased transparency in the calculation of provisioning and regulatory capital as this would:

• Allow a better understanding of the impact of current regulatory reform by providing clarity around the extent of potential increased conservatism of Basel III and the overall impact of insurance reforms
• Highlight areas of potential regulatory arbitrage by identifying the most capital efficient entity for bearing a given risk
• Enhance decision making by increasing awareness of best practice across internal modeling and highlighting areas of regulatory inconsistency
• Give a greater understanding of the quantum of capital buffers which would assist in risk/reward decisions

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