The Australian Prudential Regulation Authority (APRA) has proposed a new methodology for dealing with life insurers’ illiquidity premium when calculating regulatory capital.

APRA is proposing the illiquidity premium be added to risk-free forward rates for the first 10 years after the reporting date.

The rates would be based on the “AA spread” and “A spread” of corporate bonds that have a broad credit rating applied by Standard & Poor’s.

APRA proposes the maximum illiquidity premium would be 150 basis points and the minimum would be zero.

After the 10-year period, the illiquidity premium would be a constant 20 basis points.

“It is APRA’s view that corporate bonds are the most suitable reference for identification of the illiquidity premium,” the regulator says in a letter to life insurers.

“Corporate bonds are normally less liquid than government fixed-interest securities or interest rate swaps.”

APRA says the proposed cut-off point of 10 years was chosen because there are few corporate bonds with maturity beyond five years, while semi-government bonds are available in reasonable quantities for up to 12 years.

“The illiquidity premium of 20 basis points applying to forward rates beyond 10 years is a conservative estimate of the long-term average illiquidity premium that might be accessible to investors in the future,” it said.

APRA says in the letter that the credit risk for corporate bonds can largely be eliminated by matching them with credit default swaps.

“One method that can be used for estimating the illiquidity premium for a corporate bond is to deduct the premiums of a credit default swap with the same maturity and seniority from the bond spread,” the regulator said.

The proposed illiquidity premium rules will apply to life company annuities, fixed-term products and funeral bonds.

The industry has until June 1 to comment on these regulatory changes.