Treasury is considering removing prudential limitations on the way general insurers deal with loss absorption of regulatory capital.

It comes after the Australian Prudential Regulation Authority reviewed general insurer regulatory capital and found it suffered the same loss deficiencies as authorised deposit-taking institutions under the Basel II regulations.

Treasury says contractual loss absorption provisions do not have an established track record in Australia and have not been tested in the courts.

Historically, losses have always been imposed on investors, potentially up to the full value of the investment, and can take effect immediately. The losses would also apply when an issuer is in financial distress but not in liquidation.

A general insurer may not be able to absorb the loss and would require either a private or government capital injection.

Treasury proposes changing the contractual loss absorption provisions so insurers will not be restricted by Corporations Act requirements when adding investments such as shares.

“This will ensure these instruments can fulfil their role as regulatory capital by absorbing losses in line with their contractual terms,” Treasury says in a discussion paper. “Contractual loss absorption provisions could include provisions allowing securities to be replaced with ordinary shares, converted into ordinary shares, cancelled or written down in value.”

Treasury is assessing the implications of such changes and how legislation should be drafted, plus potential costs for administration and compliance.

Submissions on the discussion paper close on June 30.