Remuneration changes formed an important part of the Royal Commission’s recommended overhaul of the financial services sector. What this will mean for companies and their employees is now a little clearer after APRA’s recent consultation paper. To read APRA's consultation paper on strengthening prudential requirements for remuneration click here.
This is a big game for APRA
Most of the regulatory reforms fall under ASIC’s remit, but APRA is responsible for remuneration reforms as well as the new trinity of Governance, Culture and Accountability (or GCA in the language of the APRA capability review).
It is one of the first cabs off the rank because it can be done within existing powers of the regulator. APRA already has some requirements for executive remuneration in its cross-industry standard CPS510 on governance. For banks remuneration has been one of the main components of the introduction of BEAR.
For insurance companies it is also a big deal, with a lot of new requirements on an issue that has had very little regulatory attention and, of course, is very dear to the hearts of most staff.
Who has to change?
All APRA-regulated entities are captured, including branches of overseas insurers. Staff employed by service companies or related entities, or who are on some types of contracts, are also included.
However, this means that financial services entities that are not APRA-regulated are not captured. People like brokers, underwriting agencies and claim management companies are not covered. This might have some interesting ramifications in the ‘war for talent’.
While the reform is labelled as remuneration, it is really only about variable remuneration (or performance pay or bonuses in more common language). Performance pay is so wide-spread in the private sector, including financial services, that we expect virtually every company and a significant proportion of employees will be impacted in some way.
But wait, there's more
Hayne made five recommendations about remuneration. The first three mentioned APRA, and a clear response to each of these has been provided in APRA’s draft CPS511.
But what about 5.4 and 5.5?
Recommendation 5.5 is only about banks, and recommends they proceed with implementation of the Sedgwick review of staff remuneration in banks. You can learn more about Sedgwick here if you are interested, but the relevance for insurers is that it can be expected to form a template or model for staff remuneration in insurance.
Recommendation 5.4 remains (at least to us) a small mystery. It says “All financial services entities should review at least once each year the design and implementation of their remuneration systems for front line staff …” but does not say which regulatory body is in charge of making the rules and overseeing their implementation. We had assumed it would be APRA (as prudential supervisor of relevant companies) but APRA’s latest documentation is silent on 5.4. Hopefully more details will come to light soon.
So let's get started
Every insurer will need a full re-think of its performance pay system. This is not a small undertaking. As a starting point, there are two alignment tests (aka gap analysis) against:
- APRA's draft CPS511, especially for executives
- The 21 recommendations in the Sedgwick report for front-line staff.
The next stage is to move to the risk management framework. For major risks, especially non-financial or behavioural risks, where might the performance pay system be out of kilter?
With that context understood, the next step is to identify those individuals (or roles) that are in APRA’s ‘special role categories’ – they may well need different structures.
Short term incentives (e.g. annual bonus) and long term incentives (multi-year rewards, often involving equity or shadow equity) are different. LTI is usually limited to senior executives, so in this note we focus on STI which is applicable to a very wide range of staff.
It seems clear that a bonus will need to be based on a ‘balanced score-card’ approach. The keys will be to:
a) Not put too much on financial or output measures that might reward bad behaviour towards customers (in fact financial can be no more than 50%)
b) Put enough on the behavioural aspects that contribute to non-financial risk, including sanctions for bad behaviour (what APRA calls “consequences”).
c) Establish non-financial measures, both individual and team-based, that are aligned with the relevant risks and not subject to manipulation.
There will need to be a new governance process for remuneration for many companies. New work for the Board remuneration committee will include the need to consider more information, individual review of bonuses for key individuals, category-based review for all staff and an annual compliance approach.
The tricky bits
We think that almost all aspects of remuneration can be tricky, (including our own).
If you work for an insurer, this reform could well impact you personally and your work colleagues. All these people are individuals with egos, families, mortgages, legal rights and rights to privacy.
The reforms will, explicitly or implicitly, impact almost everyone’s employment arrangements. Companies will need to be communicating and consulting long before the start of the first year that new arrangements are used, expected to be 1 July 2021.
Each company is different, but here are some of the challenges:
The challenge of morale and engagement
From the start of the Royal Commission a major challenge for management has been to support the workforce – to keep people focussing on the job at hand and to avoid the despondency and loss of confidence that can come from continuing external criticism.
This remuneration reform could compound the negative sentiment. On the other hand it could be a rejuvenating time when we embrace a better future and lift the aspirations of all our organisations.
For those in leadership roles, “Your mission, should you choose to accept it…”
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