Market risk

Part

INSPRU Prudential Sourcebook for Insurers

Chapter

Market risk

Printed on: 26/11/2024

Rulebook at: 06/01/2010

INSPRU 3

Market risk

INSPRU 3.1

Market risk in insurance

31/12/2006

INSPRU 3.1.1

INSPRU 3.1 applies to an insurer, unless it is:

(1) a non-directive friendly society; or

(2) an incoming EEA firm; or

(3) an incoming Treaty firm.

31/12/2006

INSPRU 3.1.2

INSPRU 3.1 applies to pure reinsurers, with the exception of INSPRU 3.1.53 R, INSPRU 3.1.57 R and INSPRU 3.1.58 R.

31/12/2006

INSPRU 3.1.3

(1) INSPRU 3.1 applies to a firm in relation to the whole of its business, except where a particular provision provides for a narrower scope.

(2) Where a firm carries on both long-term insurance business and general insurance business, INSPRU 3.1 applies separately to each type of business.

31/12/2006

Purpose

INSPRU 3.1.4

This section sets out rules and guidance relating to market risk. Under INSPRU 1.1.20 R and INSPRU 1.1.21 R, a firm is required to hold admissible assets of a value sufficient to cover its technical provisions and its other long-term insurance or general insurance liabilities. In addition, INSPRU 1.1.34 R sets the requirement that a firm must hold assets of appropriate amount, currency, term, safety and yield, to ensure that the cash inflows from those assets will be sufficient to meet expected cash outflows from its insurance liabilities as they are due.

31/12/2006

INSPRU 3.1.5

Market risk is the risk that as a result of market movements a firm may be exposed to fluctuations in the value of its assets, the amount of its liabilities, or the income from its assets. Sources of general market risk include movements in interest rates, equities, exchange rates and real estate prices. It is important to note that none of these sources of risk is independent of the others. For example, fluctuations in interest rates often have an impact upon equity and currency values and vice versa. Giving due consideration to these correlations is an important aspect of the prudent management of market risk.

31/12/2006

INSPRU 3.1.6

A firm may also be exposed to specific market risk, which is the risk that the market value of a specific asset, or income from that asset, may fluctuate for reasons that are not dependent on general market movements. The limits in INSPRU 2.1.22 R cover market risk as well as counterparty risk.

31/12/2006

INSPRU 3.1.7

INSPRU 3.1 addresses the impact of market risk on insurance business in the ways set out below:

(1) Any firm that carries on long-term insurance business which is a regulatory basis only life firmmust comply with the resilience capital requirement. This requires the firm to hold capital to cover market risk. The resilience capital requirement is dealt with in INSPRU 3.1.9 G to INSPRU 3.1.26 R.

(2) For a firm that carries on long-term insurance business, the assets that it must hold must be of a value sufficient to cover the firm's technical provisions and other long-term insurance liabilities. INSPRU 1.2 contains rules and guidance as to the methods and assumptions to be used in calculating the mathematical reserves. One of these assumptions is the assumed rate of interest to be used in calculating the present value of future payments by or to a firm. INSPRU 3.1.28 R to INSPRU 3.1.48 G set out the methodology to be used in relation to long-term insurance liabilities.

(3) Firms carrying on either long-term insurance business or general insurance business are also subject to currency risk. That is, the risk that fluctuations in exchange rates may impact adversely on a firm. INSPRU 3.1.49 G to INSPRU 3.1.56 G set out the requirements a firm must meet so as to cover this risk.

(4) For a firm carrying on general insurance business, the Enhanced Capital Requirement already captures some elements of market risk. In addition, the requirements as to the assumed rate of interest used in calculating the present value of general insurance liabilities are contained in the insurance accounts rules, and these requirements are outlined in INSPRU 3.1.27 G.

(5) Firms carrying on long-term insurance business that have property-linked liabilities or index-linked liabilities must cover these liabilities by holding appropriate assets. INSPRU 3.1.57 R and INSPRU 3.1.58 R set out these cover requirements.

(6) The Reinsurance Directive applies to pure reinsurers "prudent person" investment principles in relation to the investment of their assets. INSPRU 3.1.61A R sets out these principles.

31/12/2006

Definitions

INSPRU 3.1.8

For the purposes of INSPRU 3.1:

(1) real estate means an interest in land, buildings or other immovable property;

(2) a significant territory is any country or territory in which more than 2.5% of a firm's long-term insurance assets (by market value), excluding assets held to cover index-linked liabilities or property-linked liabilities (see INSPRU 3.1.57 R and INSPRU 3.1.58 R), are invested;

(3) the long term gilt yield means the annualised equivalent of the fifteen year gilt yield for the United Kingdom Government fixed-interest securities index jointly compiled by the Financial Times, the Institute of Actuaries and the Faculty of Actuaries; and

(4) the member states of the European Union which have adopted the Euro as the official currency may be treated as a single territory.

31/12/2006

Resilience capital requirement (only applicable to the long-term insurance business of regulatory basis only life firms)

INSPRU 3.1.9

The resilience capital requirement forms part of the calculation of the capital resources requirement for regulatory basis only life firms. GENPRU 2.1.23 R specifies that the CRR for a regulatory basis only life firm is equal to the MCR in GENPRU 2.1.25 R. The resilience capital requirement forms part of the MCR for a regulatory basis only life firm (see GENPRU 2.1.25R (2)(b)).

31/12/2006

INSPRU 3.1.10

(1) A regulatory basis only life firm must calculate a resilience capital requirement in accordance with (2) to (5).

(2) The firm must identify relevant assets (see INSPRU 3.1.10A R) which, after applying the scenarios in (3), have a value that is equal to the firm's long-term insurance liabilities under those scenarios.

(3) For the purpose of (2), the scenarios are:

(a) for those relevant assets invested in the United Kingdom, the market risk scenario set out in INSPRU 3.1.16 R;

(b) subject to (c) and to INSPRU 3.1.26 R, for those relevant assets invested outside of the United Kingdom, the market risk scenario set out in INSPRU 3.1.23 R; and

(i) held to cover index-linked liabilities or property-linked liabilities; or

(ii) not invested in a significant territory outside the United Kingdom;

the market risk scenario set out in INSPRU 3.1.16 R.

(4) The resilience capital requirement is the result of deducting B from A, where:

(a) A is the value of the relevant assets which will produce the result described in (2); and

(b) B is the firm's long-term insurance liabilities.

(5) In calculating the value of the firm's long-term insurance liabilities under any scenario, a firm is not required to adjust the provision made under GENPRU 1.3.4 R in respect of a defined benefits pension scheme.

31/12/2006

INSPRU 3.1.10A

In INSPRU 3.1.10 R relevant assets means a range of assets which must be selected by the firm from the assets specified in (1) and (2) in the order specified:

(1) its long-term insurance assets; and

(2) only where the firm has selected all the assets within (1), its shareholder assets, other than assets of an amount and kind required:

(a) to cover its liabilities arising outside its long-term insurance funds; or

(b) to meet any regulatory capital requirements in respect of business written outside its long-term insurance funds.

31/12/2006

INSPRU 3.1.11

The purpose of the resilience capital requirement is to cover adverse deviation from:

(1) the value of long-term insurance liabilities;

(2) the value of assets held to cover long-term insurance liabilities; and

(3) the value of assets held to cover the resilience capital requirement;

arising from the effects of market risk for equities, real estate and fixed interest securities. Other risks are not explicitly addressed by the resilience capital requirement.

31/12/2006

INSPRU 3.1.12

The amount of the resilience capital requirement calculated by the firm will depend on the firm's choice of assets held to cover the resilience capital requirement. The resilience capital requirement is held to cover not only the shortfall between the change in the value of long-term insurance liabilities and the change in the value of the assets identified to cover those liabilities, but also the change in the value of the assets identified to cover the resilience capital requirement itself.

31/12/2006

INSPRU 3.1.13

As part of the assessment of the financial resources a firm needs to hold to comply with the overall financial adequacy rule, the general stress and scenario testing rule requires a firm to carry out stress tests and scenario analyses appropriate to the major sources of risk to its ability to meet its liabilities as they fall due identified in accordance with the overall Pillar 2 rule. In considering the stress tests and scenario analyses relevant to the major sources of risk in the category of market risk, a firm should consider the extent to which the market risk scenarios set out in INSPRU 3.1.16 R to INSPRU 3.1.26 R are appropriate to the nature of its asset portfolio. A firm may judge that given the nature of its portfolio, a more severe stress should be adopted. The firm may also wish to bring in other asset classes, such as index-linked bonds, which should be stressed on appropriate bases, and to consider the impact of currency mismatching and any derivative positions held.

31/12/2006

INSPRU 3.1.13A

In the market risk scenarios set out in INSPRU 3.1.16 R to INSPRU 3.1.26 R, a firm is required to assess the changed value of its assets and liabilities in the economic conditions of the scenarios set out in INSPRU 3.1.16 R and INSPRU 3.1.23 R. A firm is required to assess the changed value of each relevant asset (as defined in INSPRU 3.1.10A R), notwithstanding any uncertainty about the appropriate valuation basis for that asset. In valuing an asset in the specified scenarios, a firm should have regard to the economic substance of the asset, rather than its legal form, and assess its value accordingly. Consider, for example, a convertible bond that is close to its conversion date and where the conversion option has value. The value of the convertible bond in the specified scenarios is likely to be sensitive primarily to equity market scenarios and to a lesser extent to interest rate scenarios. The firm should value the asset according to its expected market value in the economic conditions underlying the specified scenarios.

31/12/2006

INSPRU 3.1.13B

In determining where particular assets are invested for the purpose of determining which market risk scenario should be applied to those assets, or whether a country or territory in which a firm has invested part of its long-term insurance assets is a significant territory, a firm should generally treat:

(1) a security dealt in on a regulated market as invested in any country or territory in which a regulated market on which the security is dealt is situated;

(2) a security which is not dealt in on a regulated market as invested in the country or territory in which the issuer has its head office;

(3) an asset consisting of a claim against a debtor as invested in any country or territory where it can be enforced by legal action;

(4) real estate as invested in the country or territory in which the land, buildings or other immovable property is situated;

(5) a tangible asset as invested in the country or territory where it is situated; and

(6) a derivative or quasi-derivative as invested in the country or territory in which the assets to which the firm is exposed by reason of having entered into the derivative or quasi-derivative are situated.

Where, however, the nature of a firm's investment is such that the economic risks to which it is principally exposed are risks relating to assets invested in, or the currency of, a different country or territory to that in which are invested the assets directly invested in by the firm, then the firm should consider whether it would be more reasonable to treat the assets as invested in that other country or territory. For example, if a firm has invested in the securities of a collective investment scheme which are dealt in on a regulated market in country A, but the scheme principally invests in real estate situated in country B, the firm should consider whether its principal exposure is in fact to the country in which the underlying assets are situated (that is, country B). Another example might be where a firm has invested in a bond or other fixed interest security that is denominated in the currency of a country or territory other than that in which the security would be treated as invested under (1) or (2) above. The firm may wish to consider whether that bond or fixed interest security should be treated as invested in the country or territory of the currency of denomination.

31/12/2006

INSPRU 3.1.14

[intentionally blank]

31/12/2006

INSPRU 3.1.15

Where the resilience capital requirement is affected by the presence of derivative or quasi-derivative instruments, the firm will need to consider whether the protection afforded is of suitable length or security. The firm should include the exposure to counterparties in the credit considerations of INSPRU 3.1.41 R both before and after calculating the resilience capital requirement. If the derivative protection is very short term the firm should consider whether issues arise under INSPRU 1.2.26 R (Avoidance of future valuation strain); when a derivative expires the financial position of the firm may deteriorate as a result of, for example, falls in asset values. Unless the firm holds a further reserve, the firm is likely to need to have either undertaken a fresh protection strategy or carried through the alternative to the derivative protection (such as selling equities in place of a put option) if the existing protection expires before the financial year end. If the existing derivative protection continues beyond the time of financial year end the firm must have sufficient confidence that it can renew its derivative protection or an alternative to achieve the same effect.

31/12/2006

Market risk scenario for assets invested in the United Kingdom

INSPRU 3.1.16

In INSPRU 3.1.10R (3)(a), the market risk scenario for assets invested in the United Kingdom and for assets (including assets invested outside the United Kingdom) held to cover index-linked liabilities or property-linked liabilities which a firm must assume is:

(1) a fall in the market value of equities of at least 10% or, if greater, the lower of:

(a) a percentage fall in the market value of equities which would produce an earnings yield on the FTSE Actuaries All Share Index equal to 4/3 rds of the long-term gilt yield; and

(b) a fall in the market value of equities of 25% less the equity market adjustment ratio (see INSPRU 3.1.19 R);

(2) a fall in real estate values of 20% less the real estate market adjustment ratio for an appropriate real estate index (see INSPRU 3.1.21 R);

(3)

(a) the more onerous of either a fall or rise in yields on all fixed interest securities by the percentage point amount determined in (b);

(b) for the purpose of (a), the percentage point amount is equal to 20% of the long-term gilt yield.

31/12/2006

INSPRU 3.1.17

For the purposes of INSPRU 3.1.16R (1) and INSPRU 3.1.16R (2), a firm must:

(1) assume that earnings for equities and rack rents for real estate fall by 10%, but dividends for equities remain unaltered (see INSPRU 3.1.36 R to INSPRU 3.1.38 R); and

(2) model a fall in equity and real estate markets as if the fall occurred instantaneously.

31/12/2006

INSPRU 3.1.18

An example of INSPRU 3.1.16R (3) is that, where the long-term gilt yield is currently 6%, a firm would assume an increase of 20% in that yield, that is, a change of 1.2 percentage points. For the purpose of the scenario in INSPRU 3.1.16R (3)(a), the firm would assume a fall or rise of 1.2 percentage points in yields on all fixed interest securities.

31/12/2006

Equity market adjustment ratio

INSPRU 3.1.19

The equity market adjustment ratio referred to in INSPRU 3.1.16R (1)(b) is:

(1) if the ratio calculated in (a) and (b) lies between 75% and 100%, the result of 100% less the ratio (expressed as a percentage) of:

(a) the current value of the FTSE Actuaries All Share Index; to

(b) the average value of the FTSE Actuaries All Share Index over the preceding 90 calendar days;

(2) 0%, if the ratio calculated in (1)(a) and (b) is more than 100%; and

(3) 25%, if the ratio calculated in (1)(a) and (b) is less than 75%.

31/12/2006

INSPRU 3.1.20

In INSPRU 3.1.19 R, the average value of the FTSE Actuaries All Share Index over any period of 90 calendar days means the arithmetic mean based on levels at the close of business on each of the days in that period on which the London Stock Exchange was open for trading.

31/12/2006

Real estate market adjustment ratio

INSPRU 3.1.21

The real estate market adjustment ratio for a real estate index referred to in INSPRU 3.1.16R (2) and INSPRU 3.1.23R (2) is:

(1) if the ratio calculated in (a) and (b) lies between 90% and 100%, the result of 100% less the ratio (expressed as a percentage) of:

(a) the current value of the real estate index; to

(b) the average value of that real estate index over the three preceding financial years;

(2) 0%, if the ratio calculated in (1)(a) and (b) is more than 100%; and

(3) 10%, if the ratio calculated in (1)(a) and (b) is less than 90%.

31/12/2006

INSPRU 3.1.22

For the purpose of calculating the real estate market adjustment ratio in INSPRU 3.1.21 R, a firm should select an appropriate index of real estate values such that:

(1) the constituents of the index are reasonably representative of the nature and territory of the real estate included in the range of assets identified in accordance with INSPRU 3.1.10 R; and

(2) the frequency of, and historical data relating to, published values of the index are sufficient to enable an average value(s) of the index to be calculated over the three preceding financial years.

31/12/2006

Market risk scenario for assets invested outside the United Kingdom

INSPRU 3.1.23

In INSPRU 3.1.10R (3)(b), subject to INSPRU 3.1.26 R, the market risk scenario for assets invested outside the United Kingdom (other than assets held to cover index-linked liabilities or property-linked liabilities) which a firm must assume is, for each significant territory in which assets are invested outside the United Kingdom:

(1) an appropriate fall in the market value of equities invested in that territory, which is at least equal to the percentage fall determined in INSPRU 3.1.16 R;

(2) a fall in real estate values in that territory of 20% less the real estate market adjustment ratio for an appropriate real estate index for that territory (see INSPRU 3.1.21 R); and

(3)

(a) the more onerous of either a fall or a rise in yields on all fixed interest securities by the percentage point amount determined in (b);

(b) for the purpose of (a), the percentage point amount is equal to 20% of the nearest equivalent (in respect of the method of calculation) to the long term gilt yield.

31/12/2006

INSPRU 3.1.24

For the purposes of INSPRU 3.1.23R (1), an appropriate fall in the market value of equities invested in a significant territory must be determined having regard to:

(1) an appropriate equity market index for that territory; and

(2) the historical volatility of the equity market index selected in (1).

31/12/2006

INSPRU 3.1.25

For the purpose of INSPRU 3.1.24R (1), an appropriate equity market index for a territory is such that:

(1) the constituents of the index are reasonably representative of the nature of the equities held in that territory which are included in the range of assets identified in accordance with INSPRU 3.1.10 R; and

(2) the frequency of, and historical data relating to, published values of the index are sufficient to enable an average value(s) and historical volatility of the index to be calculated over at least the three preceding financial years.

31/12/2006

INSPRU 3.1.26

Where the assets of a firm invested in a significant territory of a kind referred to in INSPRU 3.1.23R (1), INSPRU 3.1.23R (2) or INSPRU 3.1.23R (3)(a) represent less than 0.5% of the firm's long-term insurance assets (excluding assets held to cover index-linked liabilities or property-linked liabilities), measured by market value, the firm may assume for those assets the market risk scenario for assets of that kind invested in the United Kingdom set out in INSPRU 3.1.16 R instead of the market risk scenario set out in INSPRU 3.1.23 R.

31/12/2006

Interest rates: general insurance liabilities

INSPRU 3.1.27

The rates of interest to be used for the calculation of the present values of general insurance liabilities are specified in the insurance accounts rules, except where benefits resulting from a claim must be paid in the form of an annuity, in which case the rules require calculation by recognised actuarial methods. In the case of claims not payable in the form of an annuity, the insurance accounts rules state that the rate of interest to be used must not exceed the lowest of:

(1) a rate prudently estimated by the firm to be earned by assets of the firm that are appropriate in magnitude and nature to cover the provisions for claims being discounted, during the period necessary for the payment of such claims;

(2) a rate justified by the performance of such assets over the preceding five years; and

(3) a rate justified by the performance of such assets during the year preceding the balance sheet date.

31/12/2006

Interest rates: long-term insurance liabilities

INSPRU 3.1.28

(1) The rates of interest required by INSPRU 1.2.33 R to be used by a firm for the calculation of the present value of a long-term insurance liability must not exceed 97.5% of the risk-adjusted yield (see INSPRU 3.1.30 R to INSPRU 3.1.48 G) that is expected to be achieved on:

(a) the assets allocated to cover that liability;

(b) the reinvestment of sums expected to be received from those assets (see INSPRU 3.1.45 R to INSPRU 3.1.48 G); and

(2) (1) does not apply to a long-term insurance contract in respect of which the firm has calculated a negative value for the mathematical reserves in accordance with INSPRU 1.2.24 R.

31/12/2006

INSPRU 3.1.29

For the purposes of INSPRU 3.1.28 R, the rates of interest assumed must allow appropriately for the rates of tax that apply to the investment return on policyholder assets. The rates of tax assumed must be such that the firm's total implied liability for tax arising from the allocation of assets to liabilities is not less than the firm's actual expected liability for tax for the period in respect of which tax is to be assessed.

31/12/2006

INSPRU 3.1.29A

INSPRU 3.1.28 R only applies to a long-term insurance contract in respect of which a firm has calculated mathematical reserves with a positive value. A firm may, however, also have long-term insurance contracts where the value of future cash inflows under and in respect of the contract exceeds that of outflows, allowing the firm to calculate a negative value for the mathematical reserves for that contract (see INSPRU 1.2.24 R). In calculating the present value of future net cash flows under and in respect of the contract, the firm must include margins for adverse variation in accordance with INSPRU 1.2.13 R. These margins should include margins for market risk and, where relevant, credit risk. For those margins to be sufficiently prudent as required by INSPRU 1.2.13 R, the rate of interest used may need to be higher than that which would apply under INSPRU 3.1.28 R.

31/12/2006

Risk-adjusted yield

INSPRU 3.1.30

A risk-adjusted yield on an asset must be calculated by:

(1) taking the asset together with any covering derivatives, forward transactions and quasi-derivatives;

(2) assuming that the factors which affect the yield will remain unchanged after the valuation date (see INSPRU 3.1.33 R);

(3) valuing the asset (together with any offsetting transaction) in accordance with GENPRU 1.3 (Valuation);

(4) making reasonable assumptions as to whether, and if so when, any options or other rights embedded in the asset (or in any offsetting transaction) will be exercised.

31/12/2006

INSPRU 3.1.31

Examples of calculating a combined yield for the purposes of INSPRU 3.1.30R (1):

(1) 1000 1 shares (fully paid) of ABC plc covered by a sold future on the shares. Calculating the combined yield effectively results in a position that behaves like cash (with dividend income but no capital gain or loss on the value of the assets); and

(2) where a covering derivative contains an option exercisable by the firm (e.g. a bought put option or receiver swaption), the calculation of the risk adjusted yield should take into account the fact that on the valuation assumptions any time value will reduce over time (known as the 'wasting' nature of the time value of the option), for example, an at-the money option will expire worthless and hence the covering derivative will effectively be a negative yielding asset. There are various ways of allowing for this, for example a firm could treat the covering derivative and the asset as a single asset and calculate an internal rate of return on this combined asset. Alternatively, an explicit reserve could be set up equal and opposite to the time value of the covering derivative which would be written off in the same way as the time value on the covering derivative.

31/12/2006

INSPRU 3.1.32

The requirements in relation to offsetting transactions are set out in INSPRU 3.2. The options and other rights referred to in INSPRU 3.1.30R (4) include those exercisable by the firm as well as those exercisable by other parties.

31/12/2006

INSPRU 3.1.33

For the purpose of INSPRU 3.1.30R (2), the factors that affect yield should be ascertained as at the valuation date (that is, the date to which present values of cash flows are being calculated). All changes known to have occurred by that date must be taken into account including:

(1) changes in the rental income from real estate;

(2) changes in dividends or audited profit on equities;

(3) known or forecast changes in dividends which have been publicly announced by the issuer by the valuation date;

(4) known or forecast changes in earnings which have been publicly announced by the issuer by the valuation date;

(5) alterations in capital structure; and

(6) the value (at the most recent date at or before the valuation date for which it is known) of any determinant of the amount of any future interest or capital payment.

31/12/2006

INSPRU 3.1.34

The risk-adjusted yield is either:

(1) (for equities and real estate) a running yield (see INSPRU 3.1.36 R to INSPRU 3.1.38 R, INSPRU 3.1.41 R and INSPRU 3.1.44 R); or

(2) (for all other assets) the internal rate of return (see INSPRU 3.1.39 R, INSPRU 3.1.41 R and INSPRU 3.1.44 R).

31/12/2006

INSPRU 3.1.35

The risk-adjusted yield on a basket of assets is the arithmetic mean of the risk-adjusted yield on each asset weighted by that asset's market value.

31/12/2006

The running yield for real estate

INSPRU 3.1.36

For real estate the running yield is the ratio of:

(1) the rental income arising from the real estate over the previous 12 months; to

(2) the market value of the real estate.

31/12/2006

The running yield for equities

INSPRU 3.1.37

For equities the running yield is:

(1) the dividend yield, if the dividend yield is more than the earnings yield;

(2) otherwise, the sum of the dividend yield and the earnings yield, divided by two.

31/12/2006

INSPRU 3.1.38

For the purposes of INSPRU 3.1.37 R:

(1) the dividend yield is the ratio (expressed as a percentage) of dividend income over the previous 12 months from the equities for which the running yield is being calculated ("the relevant equities") to the market value of those equities;

(2) the earnings yield is the ratio (expressed as a percentage) of the audited profit (including exceptional items and extraordinary items) for the preceding financial year of the issuer of the relevant equities to the market value of those equities;

(3) the earnings yield must be calculated in accordance with whichever is most appropriate (to the issuer of the relevant equities) of United Kingdom, US or international generally accepted accounting practice.

31/12/2006

The internal rate of return

INSPRU 3.1.39

The internal rate of return on an asset is the annual rate of interest which, if used to calculate the present value of future income (before deduction of tax) and of repayments of capital (before deduction of tax) would result in the sum of those amounts being equal to the market value of the asset.

31/12/2006

INSPRU 3.1.40

The risk adjusted yield for a collective investment scheme may be determined as the weighted average of the yields on each of the investments held by the collective investment scheme.

31/12/2006

Credit risk

INSPRU 3.1.41

In both the running yield and internal rate of return the yield must be reduced to exclude that part of the yield that represents compensation for credit risk arising from the asset.

31/12/2006

INSPRU 3.1.42

An allowance for credit risk should be made for all securities except risk-free securities.

31/12/2006

INSPRU 3.1.43

Provision for credit risk for credit-rated securities may be made by reference to historic default rates of securities with a similar credit rating. However, allowance should be made both for any recent or expected changes in market conditions that may invalidate historic default rates and for the likelihood that the credit ratings on securities may deteriorate or (following such deterioration) that the issuer may default.

31/12/2006

INSPRU 3.1.44

Provision for credit risk for securities that are not credit-rated must be made on principles at least as prudent as those adopted for credit-rated securities.

31/12/2006

Investment and reinvestment

INSPRU 3.1.45

Except as provided in INSPRU 3.1.46 R:

(1) the risk-adjusted yield assumed for the investment or reinvestment of sterling sums (other than sums expected to be received within the next three years) must not exceed the lowest of:

(a) the higher of:

(i) the long-term gilt yield; and

(ii) the greater of:

(A) the forward gilts yield; and

(B) the forward rate on sterling interest rate swaps, reduced to exclude that part of the rate that represents compensation for credit risk;

where the forward yields and forward rates corresponding to the time when the sums are expected to be received are weighted so as to reflect the investment and reinvestment characteristics of the liabilities covered;

(b) 3% per annum, increased by two thirds of the excess, if any, of the percentage in (a) over 3% per annum; and

(2) the risk-adjusted yield assumed for the investment or reinvestment of those sterling sums expected to be received within the next three years must not exceed the risk-adjusted yield on the assets actually held adjusted linearly over the three-year period to the risk-adjusted yield determined under (1).

31/12/2009

INSPRU 3.1.46

For the with-profits insurance contracts of a realistic basis life firm, the risk-adjusted yield assumed for the investment or reinvestment of sums denominated in sterling must be no more than the greater of:

(1) the forward gilts yield; and

(2) the forward rate on sterling interest rate swaps, reduced to exclude that part of the rate that represents compensation for credit risk;

where the forward yields and forward rates corresponding to the times when the sums are expected to be received are weighted so as to reflect the investment and reinvestment characteristics of the liabilities covered.

31/12/2009

INSPRU 3.1.47

The risk-adjusted yield assumed for the investment or reinvestment of sums denominated in a currency other than sterlingmust be at least as prudent as in INSPRU 3.1.45 R and INSPRU 3.1.46 R taking into account the yields on government securities denominated in that currency.

31/12/2009

INSPRU 3.1.47A

For the purpose of INSPRU 3.1.47 R the yields on the government securities must be reduced to exclude that part of the yield that represents compensation for credit risk unless the following conditions are satisfied in relation to the issuer of those securities:

(1) a credit rating is available from at least one of the rating agencies listed in INSPRU 1.3.93 R; and

(2) the credit rating description in the first column of Table INSPRU 1.3.90 R corresponding to the lowest such credit rating is either exceptional or extremely strong or very strong.

31/12/2009

INSPRU 3.1.48

The purpose of INSPRU 3.1.45 R to INSPRU 3.1.47 R is to help protect against 'reinvestment risk'. Reinvestment risk is the risk that, when the sums are actually received, interest rates (and so yields available on assets) might have fallen below current expectations.

31/12/2006

Currency risk

INSPRU 3.1.49

Fluctuations in foreign exchange rates may impact adversely upon a firm, including where it holds an open position in a foreign currency. This is where future cash outflows (that is liabilities) in one currency are matched by future cash inflows (that is assets) in a different currency. The circumstances in which this could arise include where the firm:

(1) has entered into contracts for the purchase or sale of foreign currency; or

(2) has entered into contracts of insurance under which claims are payable in, or determined by reference to a value or price expressed in, a foreign currency; or

(3) holds assets denominated in a foreign currency.

31/12/2006

Cover for spot and forward currency transactions

INSPRU 3.1.50

A firm must cover a contract providing for the purchase or sale of foreign currency by:

(1) holding the currency that must be paid by the firm under the contract; or

(2) being subject to an offsetting transaction.

31/12/2006

INSPRU 3.1.51

The requirements in relation to cover and offsetting transactions are set out in INSPRU 3.2.

31/12/2006

Currency matching of assets and liabilities

INSPRU 3.1.52

INSPRU 1.1.34 R requires a firm to cover its liabilities with assets that enable it to match, in timing, amount and currency, the cash inflows and outflows from those assets and liabilities. This permits some currency mismatching of assets and liabilities, but only if sufficient excess assets are held to cover the exposure arising from such mismatching. The level of permitted currency mismatching is also limited by INSPRU 3.1.53 R.

31/12/2006

INSPRU 3.1.53

(1) Subject to INSPRU 3.1.54 R, a firm must hold admissible assets in each currency of an amount equal to at least 80% of the amount of its liabilities in that currency arising under or in connection with contracts of insurance (but excluding, for a firm that carries on general insurance business, any non-credit equalisation provision ), except where the amount of those assets does not exceed 7% of the assets in other currencies.

(2) In (1) references to an asset in a currency are to an asset which is expressed in or capable of being realised (without exchange risk) in that currency, and an asset is capable of being so realised if it is reasonably capable of being realised in that currency without risk that changes in exchange rates would reduce the cover for liabilities in that currency.

31/12/2008

INSPRU 3.1.53A

For the purpose of INSPRU 3.1.53 R, a firm may allocate the total credit equalisation provisions to different currencies in proportion to the split by currency of the technical provisions for credit insurance business established in accordance with GENPRU 1.3.4 R. Alternatively, another allocation which the firm is able to justify as broadly appropriate may be used.

31/12/2008

INSPRU 3.1.54

INSPRU 3.1.53 R does not apply to:

(1) a pure reinsurer; or

(2) assets held to cover index-linked liabilities or property-linked liabilities.

31/12/2006

INSPRU 3.1.55

For the purpose of INSPRU 3.1.53 R, the currency of the liability under a contract of insurance is the currency in which the cover under the contract of insurance is expressed or, if the contract does not specify a currency:

(1) the currency of the country or territory in which the risk is situated; or

(2) if the firm on reasonable grounds so decides, the currency in which the premium payable under the contract is expressed; or

(3) if, taking into account the nature of the risks insured, the firm considers it more appropriate:

(a) the currency (based on past experience) in which it expects the claims to be paid; or

(b) if there is no past experience, the currency of the country or territory in which the firm or relevant branch is established:

(i) for contracts covering risks falling within general insurance business classes 4, 5, 6, 7, 11, 12 and 13 (producer's liability only); and

(ii) for contracts covering risks falling within any other general insurance business class where, in accordance with the nature of the risks, the firm's liabilities are liabilities to be provided in a currency other than that which would result from the application of (1) or (2); or

(4) (where a claim has been notified to the firm and the firm's liability in respect of that claim is payable in a currency other than that which would result from the application of (1), (2) or (3)) the currency in which the claim is to be paid; or

(5) (where a claim is assessed in a currency known to the firm in advance and is a currency other than that which would result from the application of (1), (2), (3) or (4)) the currency in which the claim is to be assessed.

31/12/2006

INSPRU 3.1.56

The reasonable grounds in INSPRU 3.1.55R (2) include if, from the time the contract is entered into, it appears likely that a claim will be paid in the currency of the premium and not in the currency of the country in which the risk is situated.

31/12/2006

Covering linked liabilities

INSPRU 3.1.57

A firm must cover its property-linked liabilities with:

(1) (as closely as possible) the assets to which those liabilities are linked; or

(2) a property-linked reinsurance contract; or

(3) a combination of (1) and (2).

31/12/2006

INSPRU 3.1.58

A firm must cover its index-linked liabilities with:

(1) either:

(a) the assets which represent that index; or

(b) assets of appropriate security and marketability which correspond, as closely as possible, to the assets which are comprised in, or which form, the index or other reference of value to which those liabilities are linked; or

(2) a portfolio of assets whose value or yield is reasonably expected to correspond closely with the index-linked liability; or

(3) an index-linked reinsurance contract; or

(4) an index-linked approved derivative; or

(5) an index-linked approved quasi-derivative; or

(6) a combination of any of (1) to (5).

31/12/2006

INSPRU 3.1.58A

INSPRU 3.1.57 R and INSPRU 3.1.58 R do not apply to a pure reinsurer.

31/12/2006

INSPRU 3.1.59

For the purposes of INSPRU 3.1.57 R and INSPRU 3.1.58 R, a firm is not permitted to hold different assets and to cover the mismatch by holding excess assets.

31/12/2006

INSPRU 3.1.60

If a firm has incurred a policy liability which cannot be exactly matched by appropriate assets (for example the Limited Price Index (LPI)), the firm should seek to match assets that at least cover the liabilities. For example, an LPI limited to 5% per annum may be matched by an RPI bond or a fixed interest investment matching cash flows increasing at 5% per annum compound. Orders made by the Department for Work and Pensions under section 148 of the Social Security Administration Act 1992, and which are limited to 5% per annum, may also be matched by a fixed interest investment matching cash flows increasing at 5% per annum compound (see also INSPRU 3.1.61-A G).

06/04/2008

INSPRU 3.1.61

In selecting the appropriate cover, the firm should ensure that both credit risk, and the risk that the value or yield in the assets will not, in all circumstances, match fluctuations in the relevant index, are within acceptable limits. Rules and guidance relating to credit risk are set out in INSPRU 2.1.

31/12/2006

INSPRU 3.1.61-A

Where liabilities are linked to orders made under section 148 of the Social Security Administration Act 1992, firms are required by COBS 21.3.5R to notify their supervisorsbefore effecting any such business and to explain how the risks associated with this business will be safely managed. This requirement does not apply in respect of liabilities for which a limited revaluation premium has been paid to the Department for Work and Pensions so that the liability for revaluation, while still linked to section 148 orders, is limited to 5%. The risks may be mitigated by holding assets to cover an alternative index which is reasonably expected to at least cover the section 148 order (e.g. RPI plus a margin) over the duration of the link. The firm's exposure to an order under section 148 exceeding this index should be appropriately limited by putting a cap on the liabilities linked to the order so that risks are within acceptable limits.

06/04/2008

Pure reinsurers

INSPRU 3.1.61A

A pure reinsurer must invest its assets in accordance with the following requirements:

(1) the assets must take account of the type of business carried out by the firm, in particular the nature, amount and duration of expected claims payments, in such a way as to secure the sufficiency, liquidity, security, quality, profitability and matching of its investments;

(2) the firm must ensure that the assets are diversified and adequately spread and allow the firm to respond adequately to changing economic circumstances, in particular developments in the financial markets and real estate markets or major catastrophic events; the firm must assess the impact of irregular market circumstances on its assets and must diversify the assets in such a way as to reduce such impact;

(3) investment in assets which are not admitted to trading on a regulated market must be kept to prudent levels;

(4) investment in derivatives and quasi-derivatives must contribute to a reduction of investment risks or facilitate efficient portfolio management and such investments must be valued on a prudent basis, taking into account the underlying assets, and included in the valuation of the firm's assets. The firm must avoid excessive risk exposure to a single counterparty and to other derivative or quasi-derivative operations;

(5) the assets must be properly diversified in such a way as to avoid:

(a) excessive reliance on any one particular asset, issuer or group of undertakings; and

(b) accumulations of risk in the portfolio as a whole.

Investments in assets issued by the same issuer or by issuers belonging to the same group must not expose the firm to excessive risk concentration; and

(6) (5) does not apply to investment in government bonds.

31/12/2006

Application of INSPRU 3.1 to Lloyd's

INSPRU 3.1.62

INSPRU 3.1 applies to managing agents and to the Society in accordance with:

(1) for managing agents INSPRU 8.1.4 R, subject to INSPRU 3.1.65 R below; and

(2) for the Society, INSPRU 8.1.2 R.

31/12/2006

Resilience capital requirement (applicable to long-term business only)

INSPRU 3.1.63

Managing agents must calculate the amount of the resilience capital requirement for the long-term insurance business carried on through the syndicates they manage.

31/12/2006

INSPRU 3.1.64

The Society must determine the resilience capital requirement for the insurance business of each member under INSPRU 3.1.10 R as the member's proportionate share of the resilience capital requirement calculated by the managing agent for the long-term insurance business carried on through the syndicate.

31/12/2006

Currency risk: matching of assets and liabilities

INSPRU 3.1.65

For the purposes of INSPRU 3.1.53 R, a managing agent must ensure that:

(1) syndicate liabilities are covered by matching syndicate assets as required by INSPRU 3.1.53 R; or that

(2) it immediately notifies to the Society the nature and extent of any syndicate liabilities not covered by matching assets under (1).

31/12/2006

INSPRU 3.1.66

On receipt of a notification by a managing agent under INSPRU 3.1.65R (2), the Society must ensure that the liabilities in respect of the insurance business of the members in aggregate are covered with matching assets complying with INSPRU 3.1.53 R.

31/12/2006

INSPRU 3.2

Derivatives in insurance

31/12/2006

Application

INSPRU 3.2.1

This section applies to an insurer, unless it is:

(1) a non-directive friendly society; or

(2) an incoming EEA firm; or

(3) an incoming Treaty firm; or

(4) a pure reinsurer.

31/12/2006

INSPRU 3.2.2

The scope of application of INSPRU 3.2 is not restricted to firms that are subject to the relevant EU directives.

01/12/2009

INSPRU 3.2.3

(1) This section applies to a firm in relation to the whole of its business, except where a particular provision provides for a narrower scope.

(2) Where a firm carries on both long-term insurance business and general insurance business, this section applies separately to each type of business.

31/12/2006

Purpose

INSPRU 3.2.4

GENPRU 2.2.17 R requires a firm to calculate its capital resources for the purpose of GENPRU in accordance with the capital resources table, subject to the limits in GENPRU 2.2.32 R to GENPRU 2.2.41 R. The capital resources table and GENPRU 2.2.251 R require a firm to deduct from total capital resources the value of any asset included in an insurance fund which is not an admissible asset as listed in GENPRU 2 Annex 7. GENPRU 2 Annex 7 provides that a derivative, quasi-derivative or stock lending transaction will only be an admissible asset if it is approved. This section sets out the criteria for determining when a derivative, quasi-derivative or stock lending transaction is approved for this purpose. INSPRU 3.2.5 R to INSPRU 3.2.35 R set out the criteria for derivatives and quasi-derivatives. INSPRU 3.2.36 R to INSPRU 3.2.41 R set out the criteria for stock lending transactions.

31/12/2006

Derivatives and quasi-derivatives

INSPRU 3.2.5

For the purpose of GENPRU 2 Annex 7 (Admissible assets in insurance), and also in relation to permitted links, a derivative or quasi-derivative is approved if:

(1) it is held for the purpose of efficient portfolio management (INSPRU 3.2.6 R to INSPRU 3.2.7 R) or reduction of investment risk (INSPRU 3.2.8 R to INSPRU 3.2.13 G);

(2) it is covered (INSPRU 3.2.14 R to INSPRU 3.2.33 G); and

(3) it is effected or issued:

(a) on or under the rules of a regulated market; or

(b) off-market with an approved counterparty and, except for a forward transaction, on approved terms and is capable of valuation (INSPRU 3.2.34 R to INSPRU 3.2.35 R).

06/10/2007

INSPRU 3.2.5A

(1) GENPRU 2 Annex 7 R (3) requires firms to consider first whether an asset is a derivative or quasi-derivative transaction notwithstanding that it is also capable of falling within one or more other categories in GENPRU 2 Annex 7 R (1). If it is a derivative or quasi-derivative transaction it is only admissible if it satisfies the conditions for it to be approved under INSPRU 3.2.5 R. Firms should be able to justify whether or not their assets are derivatives or quasi-derivatives.

(2) A quasi-derivative is defined as a contract or asset that has the effect of a derivative contract. Quasi-derivatives may be regarded as those contracts or assets which are not derivatives but which effectively contain an embedded derivative component which significantly impacts the contracts or assets cash flow and risk profile so as to mirror the economic effect of a derivative. A derivative is defined in the Glossary as a contract for differences, a future or an option and includes a securitised derivative, which is an option or contract for differences that is listed. A securitised derivative may also be a debenture.

(3) A deposit with interest or other return calculated by reference to an index or other factor is excluded from the definition of contract for differences by article 85(2) of the Regulated Activities Order. However, if the return on the deposit is in the nature of that on a derivative (for example, an option or a future) then the deposit is a quasi-derivative.

(4) A holding in a fund investing in derivatives may or may not be a quasi-derivative depending on its ongoing investment policy and governance and any investment decisions from time to time which might deviate significantly from the investment policy. It should be treated as a quasi-derivative if its risk profile is such that the value of units in the fund is expected to mirror the value of a derivative.

(5) The assets in the following list, which is illustrative and not exhaustive, all have features which could lead to their being assumed to be quasi-derivatives:

(a) a bond whose redemption proceeds are directly linked to the performance of the FTSE 100 index but with a guaranteed minimum;

(b) an investment fund that is managed to give high leverage that mirrors a call option;

(d) a credit-linked note, that is, a security with an embedded credit default swap.

31/12/2008

Efficient portfolio management

INSPRU 3.2.6

A derivative or quasi-derivative is held for the purpose of efficient portfolio management if the firm reasonably believes the derivative or quasi-derivative (either alone or together with any other covered transactions) enables the firm to achieve its investment objectives by one of the following (or, in relation to permitted links, in a manner which includes but is not limited to):

(1) generating additional capital or income in one of the ways described in INSPRU 3.2.7 R; or

(2) reducing tax or investment cost in relation to admissible assets or permitted links; or

(3) acquiring or disposing of rights in relation to admissible assets or permitted links, or their equivalent, more efficiently or effectively.

06/10/2007

Generation of additional capital or income

INSPRU 3.2.7

The generation of additional capital or income falls within INSPRU 3.2.6R (1) where it arises from:

(1) taking advantage of pricing imperfections in relation to the acquisition and disposal (or disposal and acquisition) of rights in relation to assets the same as, or equivalent to, admissible assets or permitted links; or

(2) receiving a premium for selling a covered call option or its equivalent, the underlying of which is an admissible asset or permitted link, even if that additional capital or income is obtained at the expense of surrendering the chance of greater capital or income.

06/10/2007

Reduction of investment risk

INSPRU 3.2.8

A derivative or quasi-derivative is held for the purpose of reducing investment risk if the derivative or quasi-derivative (either alone or together with other fully covered transactions) reduces any aspect of investment risk without significantly increasing any other aspect of that risk.

31/12/2006

Significant increase in risk

INSPRU 3.2.9

For the purposes of INSPRU 3.2.8 R, an increase in risk from a derivative or quasi-derivative is significant unless:

(1) relative to any reduction in investment risk it is both small and reasonable; or

(2) the risk is remote.

31/12/2006

INSPRU 3.2.10

INSPRU 3.2.8 R does not require that a derivative or quasi-derivative has no possible adverse consequences. Often a derivative or quasi-derivative is effected to protect against a severe adverse consequence that only arises in one circumstance. In all other circumstances it may itself lead to adverse consequences, even if only because it expires worthless resulting in the loss of the purchase price. Conversely a derivative or quasi-derivative may reduce risk in a wide range of circumstances but lead to adverse consequences when a particular circumstance arises, e.g. the default of the counterparty. Only rarely does a derivative or quasi-derivative give rise to no adverse consequences in any circumstances. The test is merely that the increase in risk should not be significant, that is it should be both small and reasonable, or the risk should be remote.

31/12/2006

INSPRU 3.2.11

Firms are reminded that INSPRU 2.1 (Credit risk in insurance) sets out the different types of loss mitigation techniques.

31/12/2006

Investment risk

INSPRU 3.2.12

For the purposes of INSPRU 3.2.8 R, investment risk is the risk that the assets held by a firm:

(1) (where they are admissible assets held by the firm to cover its technical provisions) might not be:

(a) of a value at least equal to the amount of those technical provisions as required by INSPRU 1.1.20 R; or

(b) of appropriate safety, yield and marketability as required by INSPRU 1.1.34R (1)(a); or

(2) (where they are held to cover index-linked liabilities) might not be appropriate cover for those liabilities as required by INSPRU 3.1.58 R; and

(3) (where they are held to cover property-linked liabilities) might not be appropriately selected in accordance with contractual and constructive liabilities as required by INSPRU 1.5.36 R and appropriate cover for those liabilities as required by INSPRU 3.1.57 R.

31/12/2006

INSPRU 3.2.13

In assessing whether investment risk is reduced, the impact of a transaction on both the assets and liabilities should be considered. In particular, where the amount of liabilities depends upon the fluctuations in an index or other factor, investment risk is reduced where assets whose value fluctuates in the same way match those liabilities. In appropriate circumstances this may include:

(1) a derivative or quasi-derivative that is linked to the same index as the liabilities from the index-linked contracts; and

(2) a derivative or quasi-derivative whose value depends upon the factors which give rise to general insurance claims, e.g. a weather quasi-derivative.

31/12/2006

Cover

INSPRU 3.2.14

A firm must cover an obligation to transfer assets or pay monetary amounts that arises from:

(1) a derivative or quasi-derivative; or

(2) a contract (other than a contract of insurance) for the purchase, sale or exchange of assets.

31/12/2006

INSPRU 3.2.15

An obligation to transfer assets or pay monetary amounts (see INSPRU 3.2.14 R) must be covered:

(1) by assets, a liability or a provision (see INSPRU 3.2.16 R to INSPRU 3.2.24 R); or

(2) by an offsetting transaction (see INSPRU 3.2.25 R to INSPRU 3.2.27 R).

31/12/2006

INSPRU 3.2.16

An obligation to transfer assets (other than money) or to pay monetary amounts based on the value of, or income from, assets is covered if the firm holds:

(1) those assets; or

(2) in the case of an index or basket of assets, a reasonable approximation to those assets.

31/12/2006

INSPRU 3.2.17

An obligation to pay a monetary amount (whether or not falling in INSPRU 3.2.16 R) is covered if:

(1) the firm holds admissible assets or permitted links that are sufficient in value so that the firm reasonably believes that following reasonably foreseeable adverse variations (relying solely on cashflows from, or from realising, those assets) it could pay the monetary amount in the right currency when it falls due; or

(2) the obligation to pay the monetary amount is offset by a liability. An obligation is offset by a liability where an increase in the amount of that obligation would be offset by a decrease in the amount of that liability; or

(3) a provision at least equal to the value of the assets in (1) is implicitly or explicitly set up. A provision is implicitly set up to the extent that the obligation to pay the monetary amount is recognised under GENPRU 1.3 (Valuation) either by offset against an asset or as a separate liability. A provision is explicitly set up if it is in addition to an implicit provision.

06/10/2007

INSPRU 3.2.18

A firm must implicitly or explicitly set up a provision equal to the value of the assets or offsetting transactions held to cover a non-approved derivative or quasi-derivative transaction.

31/12/2006

INSPRU 3.2.19

A firm is required to cover a derivative under INSPRU 3.2.14R whether it satisfies the other conditions for approval under INSPRU 3.2.5R or not. Under INSPRU 3.2.17R a firm may cover an obligation to pay a monetary amount by setting up a provision. If the derivative is not covered at any time by other means then a provision needs to be set up to complete the cover taking into account obligations to pay monetary amounts that would arise if, for example, an obligation to transfer assets could not be met in full. By doing so, a derivative becomes covered. If it satisfies the other conditions under INSPRU 3.2.5R it is an approved derivative and may be taken into account for solvency purposes to the extent permitted by the large exposure limits and market risk and counterparty limits.

31/12/2007

INSPRU 3.2.20

Exposure to a transaction includes exposure that arises from a right at the firm's (or its subsidiary undertaking's) option to dispose of assets.

31/12/2006

INSPRU 3.2.21

Cover serves three purposes. First, it protects against exposure to loss from the transaction which is being covered. The value of the cover increases (or if the cover is a liability the amount of that liability decreases) to match any increase in obligations under the transaction.

31/12/2006

INSPRU 3.2.22

The second purpose of cover is that it prevents excessive gearing in the investment portfolio by the use of options and their equivalent. A firm is required to cover all obligations under an admissible transaction including obligations that would arise only at the option of the firm, e.g. the liability to pay the exercise price under a bought option.

31/12/2006

INSPRU 3.2.23

The third purpose of cover is that it protects against the risk that the firm may not be able to deliver assets (including money in any currency) of the right type when the obligation falls due under the transaction. An obligation to deliver assets is covered only if the firm holds those assets or has entered into an offsetting transaction that would deliver those assets when needed. An obligation to pay money is offset only if the firm holds cash in the right currency, its equivalent or assets that could reliably be converted into cash in the right currency.

31/12/2006

INSPRU 3.2.24

Cover used for one transaction must not be used for cover in respect of another transaction or any other agreement to acquire, or dispose of, assets or to pay or repay money.

31/12/2006

Offsetting transactions

INSPRU 3.2.25

An offsetting transaction means:

(1) an approved derivative, approved stock lending transaction or an approved quasi-derivative; or

(2) a covered transaction with an approved counterparty for the purchase of assets.

31/12/2006

INSPRU 3.2.26

A transaction offsets an obligation to transfer assets away from the firm only if it provides for the transfer to the firm of those assets, or their value, at the time, or before, the obligation falls due.

31/12/2006

INSPRU 3.2.27

A transaction offsets an obligation to pay a monetary amount only if it provides for that monetary amount to be paid to the firm at or before the earliest date on which the obligation might fall due.

31/12/2006

Lending and borrowing assets

INSPRU 3.2.28

Assets that have been lent by the firm are not available for cover, unless:

(1) they are non-monetary assets that have been lent under a transaction that fulfils the conditions in INSPRU 3.2.36 R; and

(2) the firm reasonably believes the assets to be obtainable (by return or re-acquisition) in time to meet the obligation for which cover is required.

31/12/2006

INSPRU 3.2.29

Assets that have been borrowed by the firm are not available for cover except as allowed by INSPRU 3.2.30 R.

31/12/2006

INSPRU 3.2.30

Borrowed money may be used as cover only where:

(1) the money has been advanced or an approved credit institution has committed itself to advance the money; and

(2) the borrowing is or would be covered.

31/12/2006

INSPRU 3.2.31

INSPRU 3.2.30 R in effect allows borrowings to be used to bridge the gap between an obligation under a transaction that might fall due at one date and cash or its equivalent that would only become due at a later date. Borrowings may not be used to gear the investment portfolio.

31/12/2006

Examples of cover requirements

INSPRU 3.2.32

Examples of cover by assets for the purposes of INSPRU 3.2.16 R:

(1) a bought put option (or a sold call option) on 1000 1 shares (fully paid) of ABC plc is covered by an existing holding in the fund of 1000 1 shares (fully paid) of ABC plc;

(2) a bought call option (or sold put option) on 1000 ordinary 1 shares (fully paid) of ABC plc is covered by cash (or its equivalent) which is sufficient in amount to meet the purchase price of the shares on exercise of the option;

(3) a bought or sold contract for differences on short-dated sterling is covered by cash (or its equivalent), the value of which together at least match the notional principal of the contract. For example, a LIFFE short sterling contract, or a successive series of such contracts, is covered by 500,000; and

(4) a sold future on the FT-SE 100 index is covered by holdings of equities, which satisfy the reasonable approximation test for cover in INSPRU 3.2.16R (2) in relation to that future, and the values of which together at least match the current mark to market valuation of the future. For example, if the multiplier per full point is 10, and if the eventual obligation under the future is currently 2800, the valuation of the futures position is 2800 x 10 = 28,000.

31/12/2006

INSPRU 3.2.33

Examples of cover by offsetting transactions for the purpose of INSPRU 3.2.25 R would include a bought future which is guaranteed to deliver to the firm at the relevant time sufficient assets to cover liabilities under a sold call option.

31/12/2006

Off-market transactions

INSPRU 3.2.34

For the purpose of INSPRU 3.2.5R (3)(b), a derivative or quasi-derivative is on approved terms only if the firm reasonably believes that it could, in all reasonably foreseeable circumstances and under normal market conditions, readily enter into a further transaction with the counterparty or a third party to close out the derivative or quasi-derivative at a price not less than the value attributed to it by the firm, taking into account any valuation adjustments or reserves established by the firm under GENPRU 1.3.29 R to GENPRU 1.3.34 R.

31/12/2006

INSPRU 3.2.34A

In considering whether the first transaction could be readily closed out in all reasonably foreseeable circumstances under normal market conditions, the firm should satisfy itself that it cannot reasonably foresee any circumstances in which it would need to close out all or part of the contract at a few days' notice, and would not be able to do so.

31/12/2006

INSPRU 3.2.35

For the purpose of INSPRU 3.2.5R (3)(b), a derivative or quasi-derivative is capable of valuation only if the firm:

(1) is able to value it with reasonable accuracy on a reliable basis in compliance with GENPRU 1.3.4 R; and

(2) reasonably believes that it will be able to do so throughout the life of the transaction.

31/12/2006

INSPRU 3.2.35A

The purpose of INSPRU 3.2.34 R and INSPRU 3.2.35 R is to ensure the appropriate application of GENPRU 1.3 to derivatives and quasi-derivatives effected or issued off-market with an approved counterparty.

31/12/2006

Stock lending

INSPRU 3.2.36

(1) For the purposes of GENPRU 2 Annex 7 (Admissible assets in insurance), a stock lending transaction (including a repo transaction) is approved if:

(a) the assets lent are admissible assets;

(b) , the counterparty is an authorised person, an approved counterparty, a person registered as a broker-dealer with the Securities and Exchange Commission of the United States of America or a bank, or a branch of a bank, supervised, and authorised to deal in investments as principal, with respect to OTC derivatives by at least one of the following federal banking supervisory authorities of the United States of America:

(i) the Office of the Comptroller of the Currency;

(ii) the Federal Deposit Insurance Corporation;

(iii) the Board of Governors of the Federal Reserve System; and

(iv) the Office of Thrift Supervision; and

(c) adequate and sufficiently immediate collateral (INSPRU 3.2.38 R to INSPRU 3.2.41 R) is obtained to secure the obligation of the counterparty.

(2) INSPRU 3.2.36R (1)(c) does not apply to a stock lending transaction made through Euroclear Bank SA/NV's Securities Lending and Borrowing Programme.

31/12/2008

INSPRU 3.2.36A

(1) For the purposes of the rules on permitted links, a stock lending transaction (including a repo transaction) is approved if:

(a) the assets lent are permitted links;

(b) the counterparty is an authorised person, an approved counterparty, a person registered as a broker-dealer with the Securities and Exchange Commission of the United States of America or a bank, or a branch of a bank, supervised, and authorised to deal in investments as principal, with respect to OTC derivatives by at least one of the following federal banking supervisory authorities in the United States of America:

(i) the Office of the Comptroller of the Currency;

(ii) the Federal Deposit Insurance Corporation;

(iii) the Board of Governors of the Federal Reserve System; and

(iv) the Office of Thrift Supervision; and

(c) adequately and sufficiently immediate collateral (INSPRU 3.2.38 R to INSPRU 3.2.41 R) is obtained to secure the obligation of the counterparty; and

(d) provided that, for the purposes of property-linked assets only:

(i) where the linked policyholder bears the whole of the risk associated with the stock lending transaction, they must receive the whole of the recompense (net of fees and expenses);

(ii) the extent of any risk that the linked policyholder bears in relation to the stock lending transaction must be disclosed to them; and

(iii) where the risk associated with the stock lending transaction is borne outside the linked fund, the linked fund should receive a fair and reasonable recompense for the use of the linked policyholders' funds.

(2) INSPRU 3.2.36R (1)(c) does not apply to a stock lending transaction made through Euroclear Bank SA/NVs Securities Lending and Borrowing Programme.

06/10/2007

INSPRU 3.2.37

INSPRU 3.2.36 R refers only to stock lending transactions where the firm is the lender. There are no special rules for a transaction under which the firm borrows securities.

31/12/2006

Collateral

INSPRU 3.2.38

For the purposes of INSPRU 3.2.36R (1)(c), collateral is adequate only if it:

(1) is transferred to the firm or its agent or, in the case of a letter of credit, meets the conditions described in INSPRU 3.2.38A R;

(2) is, at the time of the transfer or, in the case of a letter of credit, at the time of issue, at least equal in value to the value of the securities transferred, or consideration provided, by the firm; and

(3) is of adequate quality.

31/12/2006

INSPRU 3.2.38A

The conditions referred to in INSPRU 3.2.38R (1) are that the letter of credit is:

(1) direct, explicit, unconditional and irrevocable; and

(2) issued by an undertaking which is:

(a) not a related undertaking of the counterparty; and

(b) either an approved credit institution or a bank, or a branch of a bank, whether chartered by the federal government of the United States of America or a US state, that is supervised and examined by at least one of the following US federal banking supervisory authorities:

(i) the Office of the Comptroller of the Currency;

(ii) the Federal Deposit Insurance Corporation;

(iii) the Board of Governors of the Federal Reserve System; and

(iv) the Office of Thrift Supervision.

31/12/2006

INSPRU 3.2.39

For the purposes of assessing adequate quality in INSPRU 3.2.38R (3), reference should be made to the criteria for credit risk loss mitigation set out in INSPRU 2.1.16 R. The valuation rules in GENPRU 1.3 apply for the purpose of determining the value of both collateral received, and the securities transferred, by the firm. In addition, where collateral takes the form of assets transferred, under the rules in GENPRU any such asset that is not an admissible asset (see GENPRU 2 Annex 7) does not have a value.

31/12/2006

INSPRU 3.2.40

For the purposes of INSPRU 3.2.36R (1)(c), collateral is sufficiently immediate only if:

(1) it is transferred or, in the case of a letter of credit, issued before, or at the same time as, the transfer of the securities by the firm; or

(2) it will be transferred or, in the case of a letter of credit, issued, at latest, by the close of business on the day of the transfer.

31/12/2006

INSPRU 3.2.41

Collateral continues to be adequate only if its value is at all times at least equal to the value of the securities transferred by the firm. This will be satisfied in respect of collateral where the validity of the collateral or the firm's interest in the collateral is about to expire or has expired if sufficient collateral will again be transferred or issued at the latest by the close of business on the day of expiry.

31/12/2006

INSPRU 3.2.42

References in INSPRU 3.2.40R (2) and INSPRU 3.2.41 R to the close of business on the day of the transfer or the day of expiry are to close of business on that day in all time regions.

31/12/2006

Application of INSPRU 3.2 to Lloyd's

INSPRU 3.2.43

INSPRU 3.2 applies to managing agents and to the Society in accordance with:

(1) for managing agents, INSPRU 8.1.4 R; and

(2) for the Society, INSPRU 8.1.2 R.

31/12/2006