Overview of the Financial Sector Legislation Amendment

• DOFIs must become authorised general insurers under the Insurance Act 1973 (Cth) and comply with the same prudential regime that applies to local general insurers. A revised summary and discussion paper on the proposed changes to the Prudential Standards as a consequence of the new legislation and with which all general insurers, including authorised DOFIs will need to comply, was re-released on 19 December 2007 by the Australian Prudential Regulatory Authority (APRA). This was in response to submissions on the original discussion paper. Draft prudential standards, practice guides, reporting forms and instructions have also been published by APRA.
• If DOFIs do not become authorised, they must cease operating in the Australian market. 
• In order to be authorised, DOFIs must establish a presence and assets in Australia.

Limited exemptions to the requirement to hold an authorisation will exist for DOFIs that underwrite risks where insurance cover is not available in Australia. A discussion paper on the proposed exemptions was released by Federal Treasury on 20 September 2007.

To complement the new regime, the Corporations Act 2001 (Cth) will be amended to require Australian Financial Services Licence (AFSL) holders and their authorised representatives, who are licensed to deal in general insurance products, to only deal in general insurance products of Australian-authorised insurers, unless an exemption applies. 

Lloyd’s underwriters will not be subject to the changes but remain, as they presently are, subject to regulation under Part VII of the Insurance Act.

Direct offshore foreign insurers

What are the changes?

• Under the legislation, the scope of the Insurance Act has been expanded so that a person is also taken to carry on insurance business in Australia (which triggers the obligation to obtain a general insurance licence) if:

they carry on business outside Australia that would be considered to be carrying on insurance business if it was carried on in Australia, and

they act in Australia through another person, eg an agent.

As a result, DOFIs who issue insurance to Australian customers through an agent or broker will be required to hold a general insurance licence and will be subject to prudential regulation, including the requirement to have a presence in Australia and to hold sufficient assets to meet their liabilities here. Limited exemptions will be available under the Insurance Regulations (refer below).

• The current definition of ‘insurance business’ under the Insurance Act is defined to include ‘any business incidental to insurance business’. This definition has been amended to expressly encompass a set of activities which, while not exhaustive, would specifically include:

1. inducing others to enter into contracts of insurance with the person as an insurer
2. publishing or distributing a statement relating to the person’s willingness to enter into a contract of insurance as an insurer, and
3. procuring the publication or distribution of a statement relating to a person’s willingness to enter into a contract of insurance as an insurer.

This change in the definition may have the effect of including some foreign insurers who might otherwise be excluded from the new regime because their activities, in the absence of this change, might not have been considered sufficient to constitute carrying on an insurance business in Australia.

Incidental activities which take place after the insurer has entered into the contract of insurance with the insured are not, however, intended to be captured by this expanded definition. Such activities would include claims handling, operating accounts, making payments or holding records on behalf of an overseas foreign insurer.

• Where an Australian customer directly initiates contact with a DOFI outside Australia, rather than acting through an Australian insurance agent or broker, the DOFI will not be considered to be carrying on insurance business in Australia and will not be required to become APRA authorised even under the expanded scope of the Act (provided it did not initially induce the customer to enter into the insurance contract).
• Section 118 of the Act has been amended to allow a foreign insurer to appoint an expanded range of different legal entities as their agent in Australia. The current limitation on appointing an ‘individual resident’ as agent will be altered to allow the appointment of a body corporate incorporated in Australia.
• To complement these changes, with effect from 1 July 2008, the Act includes a prohibition in the Corporations Act on AFSL holders and authorised representatives from dealing in a general insurance product, unless it is from an authorised insurer, a Lloyd’s underwriter or an exemption applies. This will prevent Australian based insurance agents or brokers directly placing insurance with foreign insurers who do not actively participate in the Australian market.

Proposed exemptions

The Treasury discussion paper proposes three distinct types of exemptions from the need for a DOFI to be licensed or from the prohibition against an AFSL holder dealing with that DOFI, in situations where insurance cover is not available in Australia through authorised general insurers. These exemptions will be contained in amendments to the Insurance Regulations. Each exemption will only apply to the specified business covered by the exemption—the DOFI may still need to be licensed in respect of business not covered by the exemption. The paper leaves unclarified the position of a DOFI in accepting business claimed by an insured to be exempt. This leaves DOFIs in the unenviable position of potentially relying on an insured’s assessment of whether a particular insurance business is exempt to determine whether it is itself obliged to become a general insurer or not to accept the business.

The three exemptions currently proposed are:

(1) High value insureds exemption

This exemption will be for large Australian businesses which will be determined using a modified version of the Corporations Act test for large proprietary companies. The exemption will be available to an insured who satisfies at least one of the following criteria:

• $200 million or more in consolidated gross operating revenue for the company’s financial year
• $200 million or more of consolidated gross assets at the end of the company’s financial year, or
• 300 or more employees at the end of the financial year. 

The insured and their AFSL holding intermediary will need to self-assess the availability of the exemption. Treasury has also raised for discussion alternative tests based on size of premium or insurance cover.

(2) Atypical risks exemption

The atypical risks exemption will  apply to certain less common insurance lines.  The paper nominates the following indicative lines: kidnap and ransom, malicious product tampering, commercial shipping hull, ship owners protection and indemnity (over $50 million), asbestos, nuclear, political, environmental impairment, war and satellite or space cover. Once again, the insured (or its AFSL holding intermediary) will need to self-assess the availability of the exemption.

The AFSL holding intermediary will need to disclose to the insured the risks of insuring with a non APRA licensed insurer including the risk that the claim may have to be defended in a foreign court, the risk that premium may not be recovered or that a claim may not be paid out if the insurer becomes insolvent.

It is proposed to review the list of exempted insurance lines after three years, however additional insurance lines could be added to the exemption list in the meantime.

(3) Customised exemption

This exemption will be granted on a case by case basis, where risks cannot reasonably be placed with an authorised general insurer and the other exemptions do not apply. For example, where bad claims history means it is impossible to obtain insurance from an authorised Australian insurer or the cost of this insurance from such an insurer is prohibitive.

The test for the exemption will be criteria such as: (market) capacity, price, non-price terms and continuity of an existing relationship. Unlike the other exemptions, the availability will not be assessed by the insured. Treasury is seeking submissions on whether the assessment should be by the AFSL holder who represents the insured or by a regulator (either APRA or the Australian Securities and Investments Commission). Again, an AFSL holder will have to disclose the risks of insuring with a non APRA authorised insurer.

The proposals will be finalised following public submissions, which closed on 31 October 2007.

Prudential requirements

The current general insurance prudential standards made under the Insurance Act and administered by APRA which will apply to DOFIs and which will be of most significance for DOFIs include:

• Prudential Standard GPS 110: Capital Adequacy
• Prudential Standard GPS 120: Assets in Australia
• Prudential Standard GPS 220: Risk Management
• Prudential Standard GPS 230: Reinsurance Management
• Prudential Standard GPS 510: Governance
• Prudential Standard GPS 520: Fit and Proper.

APRA has re-released a discussion paper containing a high level summary of its proposed changes to the prudential framework and standards, which it intends to introduce to support the legislation. The paper responds to submissions made on the original version of the paper in the last quarter of 2007.

To accompany the discussion paper, APRA has also published draft prudential standards and practice guides. The final versions of the applicable prudential standards are intended to be in place by early 2008.

One of the main changes is that APRA will administer the prudential framework based on five categories of insurers, to take account of the differing risk profiles between the categories.

• Category A: Locally incorporated insurers—insurers who are incorporated in Australia and who do not fit within any of the other categories, for example wholly owned subsidiaries of a corporate group which is not an insurance group.
• Category B: Subsidiaries of local or foreign insurers—insurers who are incorporated in Australia and owned by a local or foreign insurance group other than an insurance group captive (which would be a category E insurer).
• Category C: Foreign insurers operating as a foreign branch—foreign insurers electing to carry on business in Australia through a branch.
• Category D: Association captives— insurers incorporated in Australia and owned by a professional or industry association, its members, or a combination of both and which only underwrites the business risks of the association members. Note that medical indemnity insurers owned by medical defence organisations will not be regarded as Category D, and will generally fit within Category A.
• Category E: Sole parent captives— insurers incorporated in Australia and either a corporate captive (ie an insurer which is owned by a company or company group, and exists for the purpose of underwriting the risks of those companies or their joint venture partners or contractors) or a partnership captive (ie. an insurer which is owned by a partnership and exists to underwrite the business risks of the partners/partnership).

The Explanatory Memorandum notes that establishing a branch office may be preferable for some DOFIs wishing to become authorised. Branch offices are already dealt with in the current Prudential Standards, and in some areas are less stringent than for companies. The examples given are the lower capital requirements and less extensive governance requirements for branch offices compared to companies.
At a minimum, all DOFIs that operate in Australia will be required to have a presence in Australia and keep assets in Australia that meet the necessary capital requirements.

APRA powers

The legislation gives APRA additional enforcement powers to effect the regulation of DOFIs. APRA will have the power to investigate, enter the premises of, or gather information from, entities it believes are or may be carrying on insurance business in Australia without being authorised, or who are or may be aiding, abetting, counselling or procuring that activity.

APRA will also have the power to seek an injunction from the Federal Court restricting unauthorised activity.

Reinsurers

Foreign reinsurers who establish a branch or subsidiary in Australia are currently required to be authorised under the Insurance Act, although those with no actual Australian presence are not. 

To enable Australian insurers to gain access to the global reinsurance market, the legislation will still exempt foreign reinsurers with no actual Australian presence from the requirement to be authorised in respect of their reinsurance business, unless they are a general insurer. The regulations can, however, exclude specific reinsurance contracts or types of reinsurance contracts from this exemption.

Offshore foreign reinsurers, even where they are exempt, may be indirectly affected by the changes to the Australian regulatory regime by the prudential standards applied to direct insurers in relation to their reinsurance arrangements. For example, APRA’s prudential standards discussion paper includes a proposal for non-APRA regulated foreign reinsurers to be attributed with a higher credit risk rating than will apply to reinsurers who are regulated by APRA. 

Taxation

Income taxation

Most DOFIs would currently be liable to a tax effectively equal to 3 per cent of gross premiums on general insurance policies where:

• the insured property at the time of the making of the contract is situated in Australia OR the insured event is one which can only happen in Australia, or
• the insured person is resident in Australia and an agent or representative of the insurer in Australia was in any way instrumental in inducing the entry of the insured person into that contract.

Depending on the structure adopted by a DOFI to become an authorised general insurer, and any applicable double tax agreements, the 3 per cent tax regime may no longer be available to the DOFI. It is likely that the DOFI will be required to lodge Australian income tax returns and pay tax on underwriting profits calculated in accordance with the specialist Australian tax rules applicable to insurance.

Stamp duty

Each state and territory of Australia imposes stamp duty on insurance policies.   Generally, a policy will attract duty in a particular state or territory if it relates to property in that jurisdiction or to any risk that may occur in that jurisdiction. Where the policy covers property or risks in more than one jurisdiction, there are provisions to apportion the duty. For example, duty could apply to a policy covering a landmark building in Sydney, or to commercial aviation insurance for an air fleet in each Australian port where they land.

The primary liability for stamp duty generally falls upon the insured, unless the policy is issued by an authorised general insurer under the Insurance Act. DOFIs who become authorised general insurers under the expanded legislation will need to register with the appropriate revenue office and will be liable for stamp duty and will be required to lodge returns. A DOFI may be able to make special arrangements with the revenue authorities so that the DOFI’s agent or broker is responsible for payment of the stamp duty.

Key issues for business and action items

Some of the key issues affecting DOFIs and currently authorised general insurers arising from the introduction of this legislation will be:

• What impact will this legislation have on a DOFI’s/APRA regulated general insurer’s current Australian market presence?
• What alternative arrangements or structures, if any, are possible to enable a DOFI to continue to participate in the Australian general insurance market from 1 July 2008 without being authorised? For example by having their business fronted by an APRA authorised insurer, while the DOFI reinsures the risk.
• What requirements will need to be satisfied to enable a DOFI to become an authorised general insurer in Australia? What structure (branch office or subsidiary) or agency arrangement will be best for a DOFI to become an authorised general insurer?
• What prudential obligations will be imposed or changed, and how can they be satisfied? For example for authorised general insurers, what will be the impact of a higher credit risk rating for reinsurance arrangements with non-APRA regulated foreign reinsurers?
• Should a submission to Treasury be made on the proposed exemptions? For example for corporate insureds, will the tests for the proposed high value insured exemption be too onerous?
• Where alternative arrangements or structures are adopted, what impact will this have on the Australian income tax obligations of the DOFI?
• If the DOFI becomes an authorised general insurer in Australia, in what jurisdictions must the DOFI be registered to pay stamp duty? Should the DOFI seek a special payment arrangement?

How Freehills can help

Freehills can assist you in working through the legal aspects of the above key issues to determine what impact the legislation will have on your business, and your business’ response to the changes. We have already helped clients to make submissions on the proposed amendments, and are currently assisting clients with lodging their general insurance licence applications with APRA.

This article was written by Terry Brigden, Partner and Adeline Hiew, Senior Associate.

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