115. ‘Discretionary cover’ is a term used to describe an insurance-like product that involves no contractual obligation by the provider to meet the costs if a risk eventuates. At its discretion, the provider will consider meeting such costs.
116. The HIH Royal Commissioner recommended that the Government extend prudential regulation to all discretionary insurance-like products.
117. DMFs provide alternative means of risk management. DMFs are sometimes applied to risks for which commercial insurance may not be available or affordable. While 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 these lower costs or the market demand for tailored products that commercial insurers do not provide.
118. The review noted that the withdrawal of DMF services could affect consumers who have found it difficult to obtain specialised insurance cover.
119. The review found that DMFs comprise less than one-half of one per cent of the insurance market. As such, the failure of a DMF is unlikely to pose any systemic threat to the industry, or given their current scope, the economy as a whole.
120. However, the expansion of the DMF sector without adequate supervision or regulation could weaken the security of the insurance industry.
121. The key findings of the review in relation to DMFs are as follows:
- Require cover to be offered only as a contract of insurance under the Insurance Act unless APRA considers in the case of an individual entity that no contingent risk that would need to be met by additional undefined member contributions is retained in the entity (in these cases such risks would fall on a general insurer providing ‘top-up cover’3).
- Require APRA to collect and collate data on business written by DMFs under the exemption.
122. The Government does not intend to regulate discretionary cover that is ‘carried on’ by State or local governments.
123. The review recommendations seek to target prudential supervision where it is justified without unnecessarily penalising DMFs filling market gaps.
124. The exemption for no contingent risk, while unusual for prudential regulation in general, recognises that some DMFs might be structured in a way that does not warrant prudential regulation.
Treasury invites comments on whether the objectives of the review recommendations are appropriate.
If the objectives are appropriate, is implementation of the recommendations the best means of achieving the objectives?
What will be the implications of the recommendations on the supply of insurance and insurance-like products in Australia?
125. Implementing the review recommendations for DMFs poses a number of issues in terms of defining and implementing the criteria involved. Matters to address include:
- a mechanism for prudentially regulating DMFs;
- defining ‘contingent risk’;
- the structure of an exemption for no contingent risk;
- determining eligibility for a no contingent risk exemption;
- data to be collected from DMFs;
- transitional arrangements and APRA enforcement powers; and
- any need for additional consumer protection measures to be placed on exempt DMFs.
126. One option for implementing the review recommendations is to introduce legislation that would regulate the provision of discretionary cover — ensuring that it could only be offered in situations where the DMF carries no contingent risk. Alternatives for DMFs that could not offer products without retaining some contingent risk would be to cease operation or to restructure to become an authorised insurer. Paragraph 170 explores these options.
127. As a base structure, the legislation could state that entities are prohibited from doing activity X unless (a) it is done under a contract of insurance, or (b) it is undertaken with no contingent risk retained by the entity. In this case, X would be a definition of writing insurance or insurance-like business that captures discretionary arrangements.
Defining the business of DMFs
128. In defining activity X, a definition of insurance and insurance-like business is required.
129. The Medical Indemnity (Prudential Supervision and Product Standards) Act 2003, which requires previously discretionary medical indemnity cover to be provided by contracts of insurance, defines the provision of medical indemnity cover with reference to the person receiving the cover and the nature of claims covered. Such a definition may not prove feasible in this situation as there are a variety of products, risks covered and potential clients.
130. A definition that relies on the basic principle of a provision of an indemnity, whether or not by binding contract, is likely to be too broad. Not all risk management tools provided in forms other than insurance contracts are DMF cover.
131. Another possibility would be to refer to the discretionary provision of indemnification that, were it not for its lack of a clear right to indemnification, would be considered insurance.
Would any of these definitions capture the full range of discretionary insurance-like products provided by DMFs?
What alternative definitions could be used?
Are there any unintended consequences from any of these definitions?
132. In order to shape an exemption from prudential regulation for DMFs carrying no contingent risk, it is first necessary to determine what is meant by ‘contingent risk’. No clear definition is provided in the review and subsequent discussions with stakeholders have not yielded a uniform view of what constitutes contingent risk.
133. A DMF will meet the cost of a claim from either or both of:
- the DMF’s retained funds; and
- any external or ‘top-up’ insurance purchased.
134. Thus, the review noted that a DMF will commonly retain a limited initial level of risk for individual claims (that is, to fund small claims and the lower end of larger claims). It may then obtain external insurance to cover the rest of its risks. A prudently managed DMF relies on adequate external insurance to control its risk exposure.
135. A possible definition of contingent risk may be based on the extent to which a legitimate claim on a DMF might not be able to be paid from these two sources of funds and the extent to which a call for additional funds may be made on members.
136. This could occur with one large claim that exceeds the capacity of the DMF’s retained funds and external insurance (Example 1). A more likely scenario is where a number of claims have exhausted the DMF’s own funds but its external insurance does not meet the lower end of the claim (Example 2).
137. In diagram 1.1, a contingent risk remains should a $5 million claim be made, exceeding the $1 million pool of funds and the $3 million insurance. Such a risk could occur due to one large claim or many smaller ones.
138. A more common form of contingent risk can emerge if a DMF’s arrangement with its external insurer requires it to meet an initial level of $1 million per claim but the DMF has already exhausted its retained funds paying out other claims. Once a new claim comes in, the DMF no longer has sufficient funds to pay the claim or, should it be a large claim, to pay the first $1 million. Members face an additional contingent risk in that a call will be required for any future claims since the DMF’s funds are now exhausted.
139. Contingent risk could also apply to the risk the DMF as a whole faces that members may refuse to meet the call and therefore leave the DMF under-funded.
Is this an appropriate interpretation of contingent risk facing DMFs and their members?
Is another interpretation more appropriate?
140. If the above interpretation of contingent risk is accepted, then the contingent risk test could consider the extent to which it might be expected that a legitimate claim will be met.
141. DMFs that minimise or eliminate standard insurance-type risk to members to the degree possible – by transferring their contingent risk to external insurers – can be seen as being fully funded to an appropriate degree. DMFs that internalise risks, leaving members potentially liable for additional financial obligations or unmet claims, cannot.
Options for determining no contingent risk
142. There are a range of possible approaches to setting the point at which a DMF would qualify for exemption by divesting itself of contingent risks that would otherwise need to be met by additional undefined member contributions. Four alternative approaches include exempting a DMF that:
- has eliminated all risks to its members;
- does not allow a call on members;
- maintains assets greater than expected liabilities; or
- structures its own funds and external insurance to reduce to an acceptable level the risk that the DMF cannot meet its obligations.
Elimination of all risk
143. It is unrealistic to expect that members of a DMF should not face any risks associated with that membership. Such a requirement would impose a more stringent regime than that applying to any other prudentially-regulated institution. It is not possible to eliminate risk. For example, APRA regulation of authorised insurers does not eliminate the risk that the insurer may have inadequate funds to pay out on all claims. Rather, it ensures that those risks are appropriately managed.
144. For example, even if a DMF were to purchase external insurance to cover all known risks, the presence or absence of risk to members of the DMF or the public would still depend on the strength of the insurance arrangements.
145. DMFs should ensure that members are aware that the discretionary nature of the cover means that there are additional risks, beyond those of traditional insurance. To the extent that members of DMFs are willing to accept those risks (and associated benefits, such as lower cost), it would be inappropriate to legislate that members of DMFs bear no risk (even if such an arrangement were feasible). The existing Corporations Act regime seeks to ensure appropriate disclosure of these types of risk.
No call on members
146. The review recommendation states that the exemption should apply when the entity retains no contingent risk that would ‘need to be met by additional undefined member contributions’ (that is, a call on members).
147. Exempting DMFs that do not allow calls on members would be a straightforward way of ensuring that there would be no request for additional undefined member contributions. However, this second option would not address the risks retained by the DMF, only limit its options should those risks materialise. To an extent, such an exemption would in fact increase the risk that the DMF, once exempt, would fail to meet claims made against it.
148. That a DMF may need additional undefined member contributions can in effect be seen as an outcome of the DMF not prudently managing its risks.
Assets greater than liabilities
149. Exempting DMFs with assets (including insurance receivables) greater than expected liabilities would be a simple test, but would be significantly weaker than prudential regulation.
150. It also would not remove or address the risks associated with fluctuations in the value of both assets and liabilities. Members of the DMF would remain exposed to those risks without appropriate regulation.
151. Further, to the extent that the DMF is incorporated under the Corporations Act, its directors will already have a duty to avoid insolvent trading. Similarly, a trustee of a DMF trust will already have a fiduciary duty to exercise the care, diligence and skill that a prudent person engaged in that profession, business or employment would exercise in managing the trust’s affairs.
Use of own funds and external insurance
152. The fourth option is to exempt DMFs to the extent that risks associated with providing insurance-like arrangements are reduced to an acceptable level. This would be by way of purchasing appropriate external insurance and holding adequate assets to fund any retained risk.
153. In practice, this may mean that insurance arrangements would be made to back up the DMF such that should claims exceed the DMF’s pool of funds or the proportion of the pool allocated to any one claim, the insurer would step in. Such arrangements would need to apply both on a per claim basis and in aggregate. An appropriate aggregate retention with its external insurance cover will address the contingent risk highlighted in Example 2 in paragraph 138.
Example of insurance arrangement with no contingent risk
154. For example, Diagram 2.1 below demonstrates a basic structure in which the DMF’s pool would meet the first portion of a claim. Insurance would meet that portion of any one claim in excess of the DMF’s individual claim retention and also the full value of any claims made once the pool’s funds are exhausted. In this case, the DMF could have an arrangement with its top-up insurer that the DMF would meet the first $500,000 of any one claim (its per claim retention), with the insurer meeting amounts above that level. The DMF would have a total pool of $1 million from which to meet its share of claims payouts (its aggregate retention). Once the pool is exhausted, the external insurance would pay the value of any claims.
155. When the first claim is paid out, totalling $750,000, the DMF’s pool pays $500,000 and the insurer pays $250,000 (Diagram 2.2).
156. When a second claim of $500,000 is paid, the full amount is paid from the remaining funds in the DMF pool. The original pool of $1 million is now exhausted (Diagram 2.3).
157. When the DMF exercises its discretion and a third claim is paid out, totalling $250,000, for the DMF to be considered to have no contingent risk, the insurance cover would need to step in and pay out the full value of the claim, since the DMF has no further assets in the pool (Diagram 2.4).
158. However, a number of restrictions may be required to ensure that the risk transfer mechanism is fully effective in protecting members from contingent risk. Such rules may need to cover:
- the amount of funds that the DMF has retained compared to its retained risk levels, particularly its aggregate retention (for example, retained funds should exceed the DMF’s aggregate retention);
- the management and investment of funds retained by the DMF (for example, in an account with an AAA-rated authorised deposit-taking institution);
- the quality of the DMF’s external insurance providers (that is, from authorised insurers or exempt DOFIs only);
- the amount of external insurance cover for any one claim (that is, the DMF’s retention for any one claim plus its external insurance will fund the maximum cover the DMF offers to a member);
- the amount of external insurance cover in the aggregate (that is, external insurance will meet the full claim once the DMF has exhausted its own funds);
- the responsiveness of the external insurance arrangements to the DMF’s discretion (that is, the insurer must consider the exercise of discretion as counting against the retention per claim and in the aggregate);
- any requirement for the DMF to hold additional funds to provide protection against the risk of default by its external insurer;
- arrangements for any annual wind-up and distribution of remaining DMF assets (for example, assets may not be distributed to members or reallocated if there are outstanding liabilities); and
- any requirements in terms of legal structure and governance.
Are such criteria necessary to ensure effective risk management by the DMF? Are there alternatives?
If they are necessary, how can they be defined so as to be both practical and effective?
Given the complexity of such criteria, will any DMF qualify for exemption?
Would the costs of determining, enforcing and complying with the exemption criteria outweigh any benefits to the community overall from regulating DMFs?
159. In practice, if external insurance is adopted as the risk management mechanism, a member of a DMF may still face some individual risk (see Diagram 3 below). With a particularly large claim, the fund would meet a set portion of the claim, the insurer meet another set portion in excess of the fund’s contribution and, if the required payment exceeds the insurer’s upper limit, the individual fund member would be required to meet the balance.
160. Such a risk is comparable with the exposure faced by policyholders of authorised insurers, in that should a claim exceed the contract limit of the policy, the individual policyholder remains liable for amounts in excess of the limit.
161. With the individual fund member meeting any residual balance (as opposed to a call being made), there is no contingent risk to the members of the DMF as a group.
162. A DMF will not be required to issue contracts of insurance and be APRA-regulated if it does not retain contingent risk. There are three possible approaches to assessing whether a DMF is eligible for exemption and therefore able to continue to operate as a DMF:
- self-assessment and lodgment with APRA; and
- assessment by APRA.
163. A DMF could assess itself against the legislation establishing criteria for a DMF wishing to continue to operate. The assessment would need to be conducted by appropriately qualified and independent individuals (for example, an auditor or actuary, depending on the details of the ‘no contingent risk’ test). A DMF that considered that it met the test would continue to provide discretionary cover. A DMF that found it did not meet the requirements of the exemption would either stop providing insurance-like cover or apply to APRA for authorisation as a general insurer.
Self-assessment and lodgement with APRA
164. A DMF seeking an exemption could formally certify that it satisfies the contingent risk test, as under the self-assessment option. The certification would be submitted to APRA, but no formal assessment by APRA required. Clearly, if this option were adopted APRA would be provided with powers to assess the certification should it be considered necessary.
Assessment by APRA
165. Alternatively, the DMF could apply to APRA to be granted an exemption, providing all necessary information required by APRA to determine whether the DMF meets the no contingent risk test.
166. As APRA will, in all three cases, require powers to investigate ongoing exemptions and will be collecting data from exempt DMFs, it may be more appropriate for all applications for exemptions to be formally assessed by APRA to ensure effective removal of contingent risk before being granted.
Would self-assessment provide sufficient integrity for the successful implementation of the DMF regulatory regime?
167. In order for the Government to monitor the DMF industry and its role in meeting the needs of Australian consumers, any DMF exempt from prudential regulation will be required to provide data to APRA under the Financial Sector (Collection of Data) Act.
168. APRA would collect statistics on the number and size of DMFs operating in Australia, the lines of business they write, and, over time, changes in the DMF market. APRA would establish standards for DMFs so that they are not subject to all of the data requirements of authorised insurers.
169. Unlike most other data collected under Financial Sector (Collection of Data) Act, the information would be used to inform future policy on DMFs, rather than as part of APRA’s prudential regulation responsibilities.
Is there any particular data that would be useful in the consideration of DMFs and their role in the Australian market?
170. Some DMFs’ current structure will already meet the standards set by the no contingent risk exemption. Others will need to restructure their affairs to continue to operate as DMFs. A third set will be unable to meet the exemption criteria and will need to cease writing business as DMFs.
171. In order to allow an orderly move to the new regime, a transition period is likely to be required for the second and third sets of DMFs.
172. A transition period of two years, for example, would allow the expiration of current cover arrangements made by the DMF. The DMF would then be able to restructure to be eligible for the exemption and continue writing business as a DMF, exit the market or seek authorisation as a general insurer.
173. Some arrangement for the management in run-off of long-tail DMF cover may be required, extending beyond the transition period.
What transitional arrangements will be required to allow DMFs to adjust to the new prudential regime?
How is the wind-down of a DMF’s business best managed, given that it is currently not regulated by APRA?
174. APRA will be required to enforce the regulation of DMFs and the application of exemptions.
Does APRA require enhanced enforcement and investigative powers to establish whether the nature of a DMF’s operations is such as to require authorisation under the Insurance Act?
Application of the Corporations Act
175. The review noted that the ASIC financial requirements placed on licensees, including DMFs, are appropriate and not in need of any obvious tightening as far as DMFs are concerned.
176. The review proposed a legislative prohibition on the use of the terms ‘insurance’ and ‘insurer’ in relation to DMF products and a legislative compulsion to disclose that the cover is ‘discretionary’ and provided by an entity not prudentially regulated.
Current licensing requirements
177. Generally, a DMF that sells its products in Australia will require an Australian Financial Services Licence (AFSL).
178. A person requires an AFSL to deal in financial products or provide financial product advice in Australia. A financial product includes a facility through which a person manages a financial risk, such as:
- general insurance products; and
- like products, for example, from a DMF.
179. Financial services licensees must comply with certain obligations, including maintaining competency, ensuring their financial services are ‘provided efficiently, honestly and fairly’ and taking responsibility for the actions of authorised representatives. Where a licensee provides services to retail clients (consumers), they must also belong to an external dispute resolution scheme.
Current disclosure requirements
181. When providing financial services to retail clients, a regulated entity must disclose certain information orally and/or through written documents.
- The Financial Services Guide (FSG) provides general information about a service provider.
- The Statement of Advice (SoA) provides a written record of personal financial advice.
- The Product Disclosure Statement (PDS) discloses important information about a financial product.
182. The FSG and SoA requirements only apply to licensees and authorised representatives.
183. However, the PDS requirements apply to product issuers whether they are licensed or not.
184. A PDS includes information about significant characteristics or features of the product. Regarding products offered by DMFs, a significant feature is the discretionary nature of such products and this should be disclosed in the PDS under current requirements.
Current treatment of intermediaries
185. Insurance brokers would usually hold their own AFSL. They are subject to the same licensing, conduct and disclosure requirements as other licensees.
186. There are no additional specific disclosure requirements that apply to intermediaries that recommend or arrange for the sale of DMF products. However, brokers represent consumers and they may disclose information about DMFs when providing advice to their clients.
Are additional disclosure requirements required for DMFs or are current requirements adequate?
Application of the Insurance Contracts Act
187. The review recommended that some consumer protection provisions of the Insurance Contracts Act apply to DMF cover, including the duty of information disclosure and compulsory renewal notices for members and policyholders.
188. DMFs do not provide cover by way of a contract of insurance for the purposes of the Act because there is no legal entitlement to indemnity. As such, the Insurance Contracts Act does not apply to DMF arrangements.
Treasury invites comments on which consumer protection provisions applicable to insurance products under the Insurance Contracts Act should also apply to DMFs exempt from prudential regulation.
Given that the application of the Insurance Contracts Act hinges on the existence of a contract of insurance, how should such provisions be applied to DMFs?
Are there other matters or issues that should be addressed in the implementation of the review’s recommendations for the regulation of DMFs?
3 In this paper, reference to ‘top-up cover’ or ’external insurance’ means insurance purchased by the DMF to meet claims that exceed a certain agreed level (the retention) per claim and in the aggregate. See paragraph 154 for an example.