The Australian Prudential Regulation Authority (APRA) has released new guidance on the measurement of credit risk weighted assets relating to insurance stand-by letters of credit.

The regulator has addressed the matter via a new frequently asked question (FAQ) for authorised deposit-taking institutions (ADIs). An ADI issues an insurance stand-by letter of credit to an insurer whereby the ADI “guarantees” payment to the insurer if its reinsurer defaults.

According to the APRA FAQ, paragraph 1 of Attachment B to Prudential Standard APS 112 (Capital Adequacy: Standardised Approach to Credit Risk) sets out the credit conversion factors to be applied to different categories of non-market-related off-balance sheet transactions under the standardised approach to credit risk.

Meanwhile, paragraph 9 of Prudential Practice Guide APG 112 provides further guidance on categorising non-market-related off-balance sheet transactions.

APRA clarified that insurance stand-by letters of credit are “direct credit substitutes.” Therefore, a 100% credit conversion factor must be applied under the standardised approach.

“This is because the primary purpose of the letter of credit is to support the claims-paying ability of the reinsurer, which is a monetary or financial obligation,” APRA said.

Under paragraph 27 of Attachment B to Prudential Standard APS 113 (Capital Adequacy: Internal Ratings-based Approach to Credit Risk), ADIs using the Foundation IRB approach must generally apply the credit conversion factors in Attachment B to APS 112.

Under paragraph 31 of Attachment B to APS 113, products assigned a 100% credit conversion factor under the standardised approach are not eligible to be modelled by ADIs using the Advanced IRB approach.

The regulator said that it expects all insurance stand-by letters of credit to be assigned a credit conversion factor of 100% regardless of the issuing ADI approach to determining regulatory capital requirements.