APRA updates: Home loan serviceability and income protection insurance
Written and accurate as at: Nov 15, 2021 Current Stats & Facts
The Australian Prudential Regulation Authority (APRA) is an independent statutory authority that supervises institutions* spanning banking, insurance and super, and promotes financial system stability in Australia.
*Authorised deposit-taking institutions (eg banks, building societies and credit unions), general insurers, life insurers, friendly societies, private health insurers, reinsurance companies, and super funds (other than self-managed funds).
In broad terms, APRA works to protect the interests of depositors, insurance policyholders, and super fund members.
And, with the Australian Treasury, the Reserve Bank of Australia (RBA), and the Australian Securities and Investments Commission (ASIC), APRA works to ensure the financial system is stable, competitive and efficient.
Importantly, from time to time, APRA will issue guidance and direction to institutions regarding their operations. Below is information in relation to home loan serviceability and income protection insurance products.
APRA update: Home loan serviceability
On 6 October 2021, APRA advised that they had increased the minimum interest rate buffer it expects authorised deposit-taking institutions (ADIs) to use when assessing the serviceability of home loan applications.
APRA advised that from 1 November 2021, it expects lenders will assess a new borrower’s ability to meet their loan repayments at an interest rate at least 3.0 percentage points above the loan product rate. Importantly, this compares to a buffer of 2.5 percentage points that was commonly used prior.
Below is an excerpt from APRA’s letter to lenders, which provides some context to their updated expectations:
“The current environment for residential mortgage lending is underscored by very low interest rates and rapidly increasing housing prices. Household debt levels relative to income are high, both historically and internationally, and the rate of household credit growth is likely to exceed income growth for the foreseeable future, further adding to debt levels.
While the banking sector is well capitalised and lending standards have generally remained sound, there are heightened risks for the financial system from lending at very high levels of indebtedness*. The action that APRA is taking is to reduce financial stability risks in the system.” (APRA)
*A more highly indebted household sector presents risks to future financial stability. Highly indebted borrowers are likely to be less resilient to future shocks, such as rising interest rates or a reduction in income.
As advised by APRA, the new serviceability buffer provides an important contingency for rises in interest rates over the life of the loan, plus any unforeseen changes in a borrower’s income or expenses.
In terms of the impact of the new serviceability buffer on new borrowers, APRA advised that they expect a 50 basis points increase will reduce maximum borrowing capacity for the typical borrower by around 5%.
For more information on home loans and borrowing capacity, click here.
APRA update: Income protection insurance products
In a previous article, we covered APRA’s release of measures aimed at improving the long-term sustainability of individual (not group) income protection (IP) insurance, for the benefit of both insurers and policyholders.
Many of these measures were due to be implemented by insurers earlier this year. However, due to the complexities facing insurers around appropriate implementation, plus the impact and challenges arising from the COVID-19 pandemic, these measures were deferred.
On 12 May 2021, APRA advised of a further deferral of one of these measures until 1 October 2022—the implementation of the policy contract term. In broad terms, this measure encompasses the following:
- From 1 October 2022, APRA expects insurers will only offer new IP insurance contracts where:
- the initial contract is for a term not exceeding 5 years; and
- the policyholder may only elect to renew the contract for further periods (not exceeding 5 years) without a medical review on the terms and conditions applicable to new contracts that are then on offer by the insurer. Changes to occupation, financial circumstances, and dangerous pastimes should be considered on renewal.
Importantly, as part of the 12 May 2021 letter to insurers, APRA also advised that all other relevant measures will still take effect on 1 October 2021. In broad terms, these other measures encompass the following:
- Income at risk for all new IP insurance contracts:
- annual earnings at the time of claim, not older than 12 months, where the policyholder has predominantly stable income; and
- average annual earnings over a period of time appropriate for the occupation of the policyholder and reflective of future earnings lost as a result of the disability, where the policyholder has income that is variable.
- Income replacement ratio for all new IP insurance contracts:
- insurance benefits, taking account of all benefits paid under the IP insurance product, don’t exceed 90% of earnings at time of claim for the first six months of the claim—70% of earnings thereafter;
- indexation of benefit payments (before income offsets are taken into account) to the claimant throughout the claim duration should be limited to a suitable inflation index;
- payments to third parties to support return-to-work initiatives focused on rehabilitation and retraining (to the extent that it is possible under current legislation) may be made in addition to the income replacement limits; and
- where super contributions are excluded from income at risk, any insurance benefits related to these contributions can be paid in addition to the income replacement limits. In all instances, insurance benefits related to super contributions should be paid into a super fund and not to the claimant.
- Benefit period for IP insurance contracts:
- have effective controls in place to manage the risks associated with long benefit periods, including specific product design features (eg applying a stricter disability definition, or having lower benefit levels when claims exceed a given period); and
- set internal benchmarks for new IP insurance products with long benefit periods which reflect the risk appetite and the effectiveness of the controls.
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