Capital

Part

Integrated Prudential sourcebook

Chapter

Capital

Printed on: 25/08/2024

Rulebook at: 31/12/2004

PRU 2

Capital

PRU 2.1

Calculation of capital resources requirements

31/12/2004

Application

PRU 2.1.1

PRU 2.1 applies to an insurer unless it is:

(1) a non-directive friendly society; or
(2) a Swiss general insurer; or
(3) an EEA-deposit insurer; or
(4) an incoming EEA firm; or
(5) an incoming Treaty firm.

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PRU 2.1.2

The scope of application of PRU 2.1 is not restricted to firms that are subject to the relevant EC Directives. It applies, for example, to pure reinsurers.

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PRU 2.1.3

(1) PRU 2.1 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, PRU 2.1 applies separately to each type of business.

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PRU 2.1.4

The adequacy of a firm's capital resources needs to be assessed in relation to all the activities of the firm and the risks to which they give rise.

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PRU 2.1.5

The requirements in PRU 2.1 apply to a firm on a solo basis.

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Purpose

PRU 2.1.6

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PRU 2.1.7

This section (PRU 2.1) sets capital resources requirements for a firm. PRU 2.2 sets out how, for the purpose of this, the amounts or values of capital, assets and liabilities are to be determined. More detailed rules relating to capital, assets and liabilities are also set out in the following chapters and sections:

(1) PRU 1.3 Valuation;
(2) PRU 3 Credit risk;
(3) PRU 4 Market risk;
(4) PRU 5 Liquidity risk;
(5) PRU 6 Operational risk;
(6) PRU 7 Insurance risk; and
(7) PRU 8 Group risk.

PRU 2.1 and PRU 2.2 include appropriate cross-references to these chapters and sections.

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PRU 2.1.8

PRU 2.1 implements minimum EC standards for the capital resources required to be held by a firm undertaking business that falls within the scope of the Consolidated Life Directive (2002/83/EC) or the First Non-Life Directive (73/239/EEC) as amended.

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Main requirements

PRU 2.1.9

(1) A firm must maintain at all times capital resources equal to or in excess of its capital resources requirement (CRR).
(2) A firm which is a participating insurance undertaking and, in relation to its own group capital resources, is in compliance with PRU 8.3.9 R, is deemed to comply with (1).

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PRU 2.1.10

A firm must comply with PRU 2.1.9 R separately in respect of both its long-term insurance business and its general insurance business.

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PRU 2.1.11

In order to comply with PRU 2.1.10 R, a firm carrying on both general insurance business and long-term insurance business will need to allocate its capital resources between its general insurance business and long-term insurance business so that the capital resources allocated to its general insurance business are equal to or in excess of its CRR for its general insurance business and the capital resources allocated to its long-term insurance business are equal to or in excess of its CRR for its long-term insurance business. Whereas long-term insurance assets cannot be used towards meeting a firm's CRR for its general insurance business, surplus general insurance assets may be used towards meeting the CRR for its long-term insurance business (see PRU 7.6.30 R to PRU 7.6.32 G). PRU 7.6 sets out the detailed requirements for the separation of long-term and general insurance business.

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PRU 2.1.12

Firms commonly use different terminology for the various PRU requirements. For example, the MCR is traditionally known as the required minimum margin.

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PRU 2.1.13

The FSA may impose a higher capital requirement than the minimum requirement set out in this section as part of the firm's Part IV permission. (See PRU 2.3).

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Calculation of the CRR

PRU 2.1.14

The CRR for any firm carrying on general insurance business is equal to the MCR in PRU 2.1.21 R.

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PRU 2.1.15

The CRR for any firm to which this rule applies (see PRU 2.1.16 R and PRU 2.1.17 R) is the higher of:

(1) the MCR in PRU 2.1.22 R; and
(2) the ECR in PRU 2.1.34 R.

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PRU 2.1.16

Subject to PRU 2.1.17 R, PRU 2.1.15 R applies to a firm carrying on long-term insurance business, other than:

(1) a non-directive mutual;
(2) a firm which has no with-profits insurance liabilities; and
(3) a firm which has with-profits insurance liabilities that are, and at all times since 31 December 2004 (the coming into force of PRU 2.1.15 R) have remained, less than £500 million.

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PRU 2.1.17

PRU 2.1.15 R also applies to a firm of a type listed in PRU 2.1.16 R (3) if:

(1) the firm makes an election that PRU 2.1.15 R is to apply to it; and
(2) that election is made by written notice given to the FSA in a way that complies with the requirements for written notice in SUP 15.7.

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PRU 2.1.18

The effect of PRU 2.1.16 R (3) is that a firm to which PRU 2.1.15 R applies because it has with-profits insurance liabilities of £500 million or more, will continue to be subject to PRU 2.1.15 R even if its with-profits insurance liabilities fall below £500 million. However, if that happens, it may apply for a waiver from PRU 2.1.15 R under section 148 of the Act. In exercising its discretion under section 148 of the Act, the FSA will have regard (among other factors) to whether there has been a material and permanent change to the firm's business and to the prospects of it continuing to have with-profits insurance liabilities of less than £500 million.

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PRU 2.1.19

A firm that has always had with-profits insurance liabilities of less than £500 million since PRU 2.1.15 R came into force may wish to "opt in" to PRU 2.1.15 R and therefore become a realistic basis life firm. By doing so, it becomes obliged to calculate a with-profits insurance capital component (see PRU 2.1.34 R and PRU 7.4), but it also becomes entitled to certain modifications to the way that a firm is required to calculate its mathematical reserves (see PRU 7.3.46 R and PRU 7.3.76 R). The firm is also then required to report its liabilities on a realistic basis (see IPRU(INS) rule 9.31R(b)). In order to "opt in", the firm must make an election under PRU 2.1.17 R that PRU 2.1.15 R is to apply to it. If a firm that has elected to calculate and report its with-profits insurance liabilities on a realistic basis subsequently decides that it no longer wishes to do so, it may seek to "opt out" by applying for a waiver from PRU 2.1.15 R under section 148 of the Act. In exercising its discretion under section 148 of the Act, the FSA will have regard (among other factors) to whether there has been a material and permanent change to the firm's business and to whether it continues to have with-profits insurance liabilities of less than £500 million.

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PRU 2.1.20

The CRR for a firm carrying on long-term insurance business, but to which PRU 2.1.15 R does not apply, is equal to the MCR in PRU 2.1.22 R.

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Calculation of the MCR

PRU 2.1.21

For a firm carrying on general insurance business, the MCR in respect of that business is the higher of:

(1) the base capital resources requirement for general insurance business applicable to that firm; and
(2) the general insurance capital requirement.

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PRU 2.1.22

For a firm carrying on long-term insurance business, the MCR in respect of that business is the higher of:

(1) the base capital resources requirement for long-term insurance business applicable to that firm; and
(2) the sum of:

(a) the long-term insurance capital requirement; and
(b) the resilience capital requirement.

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PRU 2.1.23

The MCR gives effect to the EC Directive minimum requirements. For general insurance business, the EC Directive minimum is the higher of the general insurance capital requirement and the relevant base capital resources requirement. For long-term insurance business, the EC Directive minimum is the higher of the long-term insurance capital requirement and the base capital resources requirement. The base capital resources requirement is the minimum guarantee fund for the purposes of article 29(2) of the Consolidated Life Directive (2002/83/EC) and article 17(2) of the First Non-Life Directive (73/239/EEC) as amended. The resilience capital requirement is an FSA requirement that is additional to the EC minimum requirement for long-term insurance business.

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PRU 2.1.24

The calculation of the resilience capital requirement is set out in PRU 4.2.

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Calculation of the base capital resources requirement

PRU 2.1.25

The amount of a firm's base capital resources requirement is set out in Table 2.1.26R.

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PRU 2.1.26

Table: Base capital resources requirement

Firm type

Amount: Currency equivalent of

General insurance business

Liability insurer
(classes 10-15)

Directive mutual

€2.25 million

Non-directive insurer

€300,000

Overseas firm

€1.5 million

Other

€3 million

Other insurer

Directive mutual

€1.5 million

Non-directive insurer
(classes 1 to 8, 16 or 18)

€225,000

Non-directive insurer
(classes 9 or 17)

€150,000

Overseas firm

€1 million

Other

€2 million

Long-term insurance business

Mutual

Directive

€2.25 million

Non-directive

€600,000

Overseas firm

€1.5 million

Any other insurer

€3 million

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PRU 2.1.27

(1) Subject to (2) and (3), the amount of the base capital resources requirement specified in the last column of the table in PRU 2.1.26 R for a firm which is not a non-directive insurer will increase each year, starting on the review date of 20 September 2005 (and annually after that), by the percentage change in the European index of consumer prices (comprising all EU member states, as published by Eurostat) from 20 March 2002, to the relevant review date, rounded up to a multiple of €100,000.
(2) In any year, if the percentage change since the last increase is less than 5%, then there will be no increase.
(3) The increase will take effect 30 days after the EU Commission has informed the European Parliament and Council of its review and the relevant percentage change.

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PRU 2.1.28

Any increases in the base capital resources requirement referred to in PRU 2.1.27 R will be published on the FSA website.

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PRU 2.1.29

For the purposes of the base capital resources requirement, the exchange rate from the Euro to the pound sterling for each year beginning on 31 December is the rate applicable on the last day of the preceding October for which the exchange rates for the currencies of all the European Union member states were published in the Official Journal of the European Union.

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Calculation of the general insurance capital requirement

PRU 2.1.30

A firm must calculate its general insurance capital requirement as the highest of:

(1) the premiums amount;
(2) the claims amount; and
(3) the brought forward amount.

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PRU 2.1.31

The calculation of each of the premiums amount, claims amount and brought forward amount is set out in PRU 7.2.

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Calculation of the long-term insurance capital requirement

PRU 2.1.32

A firm must calculate its long-term insurance capital requirement as the sum of:

(1) the insurance death risk capital component;
(2) the insurance health risk capital component;
(3) the insurance expense risk capital component; and
(4) the insurance market risk capital component.

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PRU 2.1.33

The calculation of each of the capital components is set out in PRU 7.2.

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Calculation of the ECR

PRU 2.1.34

For a firm carrying on long-term insurance business, the ECR in respect of that business is the sum of:

(1) the long-term insurance capital requirement;
(2) the resilience capital requirement; and
(3) the with-profits insurance capital component.

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PRU 2.1.35

Details of the resilience capital requirement and the with-profits insurance capital component are set out in PRU 4.2 and PRU 7.4 respectively.

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Monitoring requirements

PRU 2.1.36

A firm must at all times monitor whether it is complying with PRU 2.1.9 R and be able to demonstrate that it knows at all times whether it is complying with that rule.

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PRU 2.1.37

For the purposes of PRU 2.1.36 R, a firm should have systems in place to enable it to be certain whether it has adequate capital resources to comply with PRU 2.1.9 R at all times. This does not necessarily mean that a firm needs to measure the precise amount of its capital resources and its CRR on a daily basis. A firm should, however, be able to demonstrate the adequacy of its capital resources at any particular time if asked to do so by the FSA.

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PRU 2.1.38

A firm must notify the FSA immediately of any breach, or expected breach, of PRU 2.1.9 R.

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PRU 2.2

Capital resources

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Application

PRU 2.2.1

PRU 2.2 applies to an insurer unless it is:

(1) a non-directive friendly society; or
(2) a Swiss general insurer; or
(3) an EEA-deposit insurer; or
(4) an incoming EEA firm; or
(5) an incoming Treaty firm.

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Purpose

PRU 2.2.2

PRU 2.1 sets out minimum capital resources requirements for a firm. This section (PRU 2.2) sets out how, for the purpose of these requirements, capital resources are defined and measured. PRU 2.2 also implements minimum EC standards for the composition of capital resources required to be held by a firm undertaking business that falls within the scope of the Consolidated Life Directive (2002/83/EC) or the First Non-Life Directive (73/239/EEC) as amended.

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Principles underlying the definition of capital resources

PRU 2.2.3

The FSA has divided its definition of capital into categories, or tiers, reflecting differences in the extent to which the capital instruments concerned meet the purpose and conform to the characteristics of capital listed in PRU 2.2.5 G. The FSA generally prefers a firm to hold higher quality capital that meets the characteristics of permanency and loss absorbency that are features of tier one capital. Capital instruments falling into core tier one capital can be included in a firm's regulatory capital without limit. Typically, other forms of capital are either subject to limits (see PRU 2.2.16 R to PRU 2.2.26 R) or, in the case of some specialist types of capital, may only be included with the express consent of the FSA (which takes the form of a waiver under section 148 of the Act).

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PRU 2.2.4

Details of the individual components of capital are set out in PRU 2.2.14 R.

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Tier one capital

PRU 2.2.5

Tier one capital typically has the following characteristics:

(1) it is able to absorb losses;
(2) it is permanent;
(3) it ranks for repayment upon winding up after all other debts and liabilities; and
(4) it has no fixed costs, that is, there is no inescapable obligation to pay dividends or interest.

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PRU 2.2.6

The forms of capital that qualify for tier one capital are set out in PRU 2.2.14 R and include, for example, share capital, reserves, verified interim net profits and, for a mutual, the initial fund plus permanent members' accounts. Tier one capital is divided into core tier one capital, perpetual non-cumulative preference shares, and innovative tier one capital.

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Upper and lower tier two capital

PRU 2.2.7

Tier two capital includes forms of capital that do not meet the requirements for permanency and absence of fixed servicing costs that apply to tier one capital. Tier two capital includes, for example:

(1) capital which is perpetual (that is, has no fixed term) but cumulative (that is, servicing costs cannot be waived at the issuer's option, although they may be deferred - for example cumulative preference shares); perpetual capital instruments may be included in upper tier two capital; and
(2) capital which is not perpetual (that is, it has a fixed term) and which may also have fixed servicing costs that cannot generally be either waived or deferred, for example subordinated debt. Such capital should normally be of a medium to long-term maturity (that is, an original maturity of at least five years). Dated capital instruments are included in lower tier two capital.

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Deductions from capital

PRU 2.2.8

Deductions should be made at the relevant stage of the calculation of capital resources to reflect capital that may not be available to the firm or assets of uncertain value, for example, holdings of intangible assets and assets that are inadmissible for a firm.

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PRU 2.2.9

A full list of deductions from capital resources is shown in PRU 2.2.14 R.

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Calculation of capital resources

PRU 2.2.10

Capital resources can be calculated either as the total of eligible assets less foreseeable liabilities (which is the approach taken in the Insurance Directives) or by identifying the components of capital. Both calculations give the same result for the total amount of capital resources. The approach taken in this section has been to specify the components of capital and the relevant deductions. This is set out in PRU 2.2.14 R. This approach is the same as that used for the calculation of capital resources for banks, building societies and investment firms. A simple example, showing the reconciliation of the two methods, is given in PRU 2.2.11 G.

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PRU 2.2.11

Table: Approaches to calculating capital resources

Liabilities

Assets

Borrowings

100

Admissible assets

350

Ordinary shares

200

Intangible assets

100

Profit and loss account and other reserves

100

Other inadmissible assets

100

Perpetual subordinated debt

150

Total

550

Total

550

Calculation of capital resources: eligible assets less foreseeable liabilities

Total assets

550

less intangible assets

(100)

less inadmissible assets

(100)

less liabilities (borrowings)

(100)

Capital resources

250

Calculation of capital resources: components of capital

Ordinary shares

200

Profit and loss account and other reserves

100

Perpetual subordinated debt

150

less intangible assets

(100)

less inadmissible assets

(100)

Capital resources

250

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PRU 2.2.12

A firm must calculate its capital resources for the purpose of PRU in accordance with PRU 2.2.14 R, subject to the limits in PRU 2.2.16 R to PRU 2.2.26 R.

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PRU 2.2.13

Where PRU 2.2.14 R refers to related text, it is necessary to refer to that text in order to understand fully what is included in the descriptions of capital items and deductions set out in the table.

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PRU 2.2.14

Table: Capital resources (see PRU 2.2.12 R )

Related text

Included in the calculation of capital resources

A √ denotes that the item is included in the calculation of a firm's capital resources: a x denotes that the item is not included in the calculation of a firm's capital resources.

(A) Core tier one capital:

Permanent share capital

PRU 2.2.36 R

√

Profit and loss account and other reserves

PRU 2.2.76 R and PRU 2.2.77 R

√

Share premium account

None

√

Externally verified interim net profits

PRU 2.2.82 R

√

Positive valuation differences

PRU 2.2.78 R

√

Fund for future appropriations

None

√

(B) Perpetual non-cumulative preference shares

Perpetual non-cumulative preference shares

PRU 2.2.50 R

√

Innovative tier one instruments

PRU 2.2.52 R to PRU 2.2.75 R

√

(D) Total tier one capital before deductions = A + B + C

(E) Deductions from tier one capital:

Investments in own shares

None

√

Intangible assets

PRU 2.2.84 R

√

Amounts deducted from technical provisions for discounting and other negative valuation differences

PRU 2.2.78 R to PRU 2.2.81 R

√

(F) Total tier one capital after deductions = D - E

(G) Upper tier two capital:

Perpetual cumulative preference shares

PRU 2.2.101 R

√

Perpetual subordinated debt

PRU 2.2.101 R

√

Perpetual subordinated securities

PRU 2.2.101 R

√

(H) Lower tier two capital

Fixed term preference shares

PRU 2.2.108 R

√

Fixed term subordinated debt

PRU 2.2.108 R

√

Fixed term subordinated securities

PRU 2.2.108 R

√

(I) Total tier two capital = G + H

(J) Positive adjustments for related undertakings

Related undertakings that are regulated related undertakings (other than insurance undertakings)

PRU 2.2.90 R

√

(K) Total capital after positive adjustments for regulated related undertakings that are not insurance undertakings but before deductions = F + I + J

(L) Deductions from total capital

Inadmissible assets

PRU 2.2.86 R & PRU 2 Annex 1R

√

Assets in excess of market risk and counterparty limits

PRU 3.2.22 R

√

PRU 2.2.89 R

√

Negative adjustments for related undertakings that are regulated related undertakings (other than insurance undertakings)

PRU 2.2.90 R

√

(M) Total capital after deductions = K - L

(N) Other capital resources*:

Unpaid share capital or, in the case of a mutual, unpaid initial funds and calls for supplementary contributions

PRU 2.2.126 G to PRU 2.2.128 G

Implicit items

PRU 2 Annex 2 G

(O) Total capital resources after deductions = M + N

* Items in section (N) of the table can be included in capital resources if subject to a waiver under section 148 of the Act.

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Limits on the use of different forms of capital

PRU 2.2.15

As the various components of capital differ in the degree of protection that they offer the firm and its customers, restrictions are placed on the extent to which certain types of capital are eligible for inclusion in a firm's capital resources. These restrictions are set out in PRU 2.2.16 R to PRU 2.2.26 R.

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PRU 2.2.16

At least 50% of a firm's MCR must be accounted for by the sum of:

(1) the amount calculated at stage A of the calculation in PRU 2.2.14 R; and
(2) notwithstanding PRU 2.2.20 R (1), the amount calculated at stage B of the calculation in PRU 2.2.14 R;

less the amount calculated at stage E of the calculation in PRU 2.2.14 R.

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PRU 2.2.17

A firm carrying on long-term insurance business must meet the higher of:

(1) 1/3 of the long-term insurance capital requirement; and
(2) the base capital resources requirement;

with the sum of the items listed at stages A, B, G and H less the sum of the items listed at stage E in PRU 2.2.14 R.

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PRU 2.2.18

A firm carrying on general insurance business must meet the higher of:

(1) 1/3 of the general insurance capital requirement; and
(2) the base capital resources requirement;

with the sum of the items listed at stages A, B, G and H less the sum of the items listed at stage E in PRU 2.2.14 R.

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PRU 2.2.19

The purposes of the requirements in PRU 2.2.16 R to PRU 2.2.18 R are to comply with the Insurance Directives' requirement that firms maintain a guarantee fund of higher quality capital resources items and to ensure that at least 50% of the firm's capital resources needed to meet its MCR provide maximum loss absorbency to protect the firm from insolvency.

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PRU 2.2.20

In relation to a firm's tier one capital resources calculated at stage F of the calculation in PRU 2.2.14 R:

(1) at least 50% must be accounted for by core tier one capital; and
(2) no more than 15% may be accounted for by innovative tier one capital.

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PRU 2.2.21

The purpose of the requirement in PRU 2.2.20 R (1) is to ensure that at least 50% of the firm's tier one capital resources (net of tier one capital deductions) is met by core tier one capital which provides maximum loss absorbency on a going concern basis to protect the firm from insolvency. Although a perpetual non-cumulative preference share is in legal form a share, it behaves in many ways like a perpetual fixed interest debt instrument. Within the 50% limit on non-core tier one capital, PRU 2.2.20 R (2) places a further sub-limit on the amount of innovative tier one capital that a firm may include in its tier one capital resources. This limit is necessary to ensure that most of a firm's tier one capital comprises items of capital of the highest quality.

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PRU 2.2.22

The amount of any capital item excluded from a firm's tier one capital resources under PRU 2.2.20 R may form part of its tier two capital resources subject to the limits in PRU 2.2.23 R.

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PRU 2.2.23

Subject to PRU 2.2.24 R, a firm must exclude from the calculation of its capital resources the following:

(1) the amount (if any) by which tier two capital resources exceed the amount calculated at stage F of the calculation in PRU 2.2.14 R; and
(2) the amount (if any) by which lower tier two capital resources exceed 50% of the amount calculated at stage F of the calculation in PRU 2.2.14 R.

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PRU 2.2.24

At least 75% of a firm's MCR must be accounted for by the sum of:

(1) the amount calculated at stage A plus stage B less stage E of the calculation in PRU 2.2.14 R; and
(2) the amount calculated at stage G of the calculation in PRU 2.2.14 R.

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PRU 2.2.25

PRU 2.2.23 R and PRU 2.2.24 R give effect to the Insurance Directives' requirements that a firm's tier two capital resources must not exceed its tier one capital resources and that no more than 25% of a firm's "required solvency margin" should consist of lower tier two capital resources.

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PRU 2.2.26

A firm that carries on both long-term insurance business and general insurance business must apply the limits in PRU 2.2.16 R to PRU 2.2.24 R separately for each type of business.

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Characteristics of tier one capital

PRU 2.2.27

A firm may not include a share in, or another investment in, or external contribution to the capital of, that firm in its tier one capital resources unless it complies with the following conditions:

(1) it is included in one of the categories in PRU 2.2.28 R;
(2) it is not excluded by any of the rules in PRU 2.2; and
(3) it complies with the conditions set out in PRU 2.2.29 R.

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PRU 2.2.28

The categories referred to in PRU 2.2.27 R (1) are:

(1) permanent share capital;
(2) a perpetual non-cumulative preference share; and
(3) an innovative tier one instrument.

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PRU 2.2.29

Subject to PRU 2.2.30 R, an item of capital in a firm complies with PRU 2.2.27 R (3) if:

(1) it is issued by the firm;
(2) it is fully paid and the proceeds of issue are immediately and fully available to the firm;
(3) it:

(a) cannot be redeemed at all or can only be redeemed on a winding up of the firm; or
(b) complies with the conditions in PRU 2.2.38 R and PRU 2.2.39 R;

(4) any coupon is either non-cumulative or, if it is cumulative, it complies with PRU 2.2.40 R;
(5) it is able to absorb losses to allow the firm to continue trading and in the case of an innovative tier one instrument it complies with PRU 2.2.56 R to PRU 2.2.58 R;
(6) it ranks for repayment upon winding up no higher than a share of a company incorporated under the Companies Act 1985 or the Companies (Northern Ireland) Order 1986 (whether or not it is such a share);
(7) the firm has the right to choose whether or not to pay a coupon on it in cash at any time;
(8) the description of its characteristics used in its marketing is consistent with the characteristics required to satisfy PRU 2.2.29 R (1) to PRU 2.2.29 R (7).

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PRU 2.2.30

(1) An item of capital does not comply with PRU 2.2.27 R (3) if the issue of that item of capital by the firm is connected with one or more other transactions which, when taken together with the issue of that item, could produce the effect described in (2).
(2) The effect referred to in (1) is a reduction in the economic benefit intended to be conferred on the firm by the issue of the item of capital which means that the item of capital no longer displays all of the characteristics set out in PRU 2.2.29 R (1) to (8).

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PRU 2.2.31

An item of capital does not comply with PRU 2.2.29 R (5) if the holder of that item does not bear losses to at least the same degree as the holder of a share of a company incorporated under the Companies Act 1985 or the Companies (Northern Ireland) Order 1986 (whether or not it is such a share).

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PRU 2.2.32

PRU 2.2.29 R (2) is stricter than the Companies Act definition of fully paid, which only requires an undertaking to pay.

31/10/2004

PRU 2.2.33

An item of capital does not comply with PRU 2.2.29 R (8) if it is marketed as a capital instrument that would only qualify for a lower level of capital or on the basis that investing in it is like investing in a lower tier two instrument. For example, an undated capital instrument should not be marketed as a dated capital instrument if the terms of the capital instrument include an option by the issuer to redeem the capital instrument at a specified date in the future.

31/10/2004

PRU 2.2.34

For the purposes of PRU 2.2.30 R, examples of connected transactions might include guarantees or any other side agreement provided to the holders of the capital instrument by the firm or a connected party or a related transaction designed, for example, to enhance their security or to achieve a tax benefit, but which may compromise the loss absorption capacity or permanence of the original capital item.

31/12/2004

PRU 2.2.35

A firm may not include a share in its tier one capital resources unless (in addition to complying with the other relevant rules in PRU 2.2):

(1) (in the case of a firm that is a company as defined in the Companies Act 1985 or the Companies (Northern Ireland) Order 1986) it is "called-up share capital" within the meaning given to that term in that Act or, as the case may be, that Order; or
(2) (in the case of any other firm) it is:

(a) in economic terms; and
(b) in its characteristics as capital (including loss absorbency, permanency, ranking for repayment and fixed costs);

substantially the same as called-up share capital falling into (1).

31/10/2004

Core tier one capital: permanent share capital

PRU 2.2.36

Permanent share capital means an item of capital which (in addition to satisfying PRU 2.2.29 R) meets the following conditions:

(1) it is:

(a) an ordinary share; or
(b) a members' contribution; or
(c) part of the initial fund of a mutual;

(2) any coupon on it is not cumulative, and the firm has both the right to choose whether or not to pay a coupon and the right to choose the amount of that coupon ; and
(3) the terms upon which it is issued do not permit redemption and it is otherwise incapable of being redeemed to at least the degree of an ordinary share issued by a company incorporated under the Companies Act 1985 or the Companies (Northern Ireland) Order 1986 (whether or not it is such a share).

31/10/2004

PRU 2.2.37

PRU 2.2.36 R has the effect that the firm should be under no obligation to make any payment in respect of a tier one instrument if it is to form part of its permanent share capital unless and until the firm is wound up. A tier one instrument that forms part of permanent share capital could not therefore count as a liability before the firm is wound up. The fact that relevant company law permits the firm to make earlier repayment does not mean that the tier one instruments are not eligible. However, the firm should not be required by any contractual or other obligation arising out of the terms of that capital to repay permanent share capital. Similarly a tier one instrument may still qualify if company law allows dividends to be paid on this capital, provided the firm is not contractually or otherwise obliged to pay them. There should therefore be no fixed costs.

31/10/2004

Basic rules about redemption and cumulative coupons

PRU 2.2.38

In relation to a perpetual non-cumulative preference share which is redeemable, a firm may not include it in its tier one capital resources unless its contractual terms are such that:

(1) it is redeemable only at the option of the firm; and
(2) the firm cannot exercise that redemption right:

(a) on or before the fifth anniversary of its date of issue;
(b) unless it has given notice to the FSA in accordance with PRU 2.2.72 R; and
(c) unless at the time of exercise of that right it complies with PRU 2.1.9 R and will continue to do so after redemption.

31/10/2004

PRU 2.2.39

In relation to an innovative tier one instrument which is redeemable and which, either:

(1) is or may become subject to a step-up; or
(2) satisfies PRU 2.2.54 R (2);

a firm may not include it in its tier one capital resources unless it complies with the conditions in PRU 2.2.38 R, except that in PRU 2.2.38 R (2)(a) "fifth anniversary" is replaced by "tenth anniversary".

31/10/2004

PRU 2.2.40

A potential tier one instrument with a cumulative coupon complies with PRU 2.2.29 R (4) only if any such coupon must, if deferred, be paid by the firm in the form of permanent share capital.

31/10/2004

PRU 2.2.41

PRU 2.2.38 R does not apply to permanent share capital because no item of capital that is either redeemable or that has a cumulative coupon can be permanent share capital.

31/12/2004

Further guidance on redemption

PRU 2.2.42

The rules in PRU 2.2 about redemption of potential tier one instruments fall into three classes:

(1) rules defining whether a firm's potential tier one instruments are eligible for inclusion in its tier one capital resources at all;
(2) rules defining whether a firm's potential tier one instruments are eligible for inclusion in its permanent share capital; and
(3) rules defining whether a firm's potential tier one instruments must be classified as innovative tier one instruments.

31/10/2004

PRU 2.2.43

The rules about redemption that are relevant to deciding whether a firm's potential tier one instruments are eligible for inclusion in its tier one capital resources at all are as follows.

(1) PRU 2.2.29 R (3) and PRU 2.2.39 R have the following provisions.

(a) Any capital instrument that is redeemable at the option of the holder cannot form part of a firm's tier one capital resources. Instead, if it is redeemable at all, a capital instrument should only be redeemable at the option of the firm.
(b) A redemption right should be exercisable no earlier than the fifth anniversary of the date of issue. However, if an instrument is an innovative tier one instrument which is subject to a step-up or any other economic incentive to redeem, any such redemption should be exercisable no earlier than the tenth anniversary.
(c) Any redemption proceeds should be payable only in cash or in shares.
(d) The terms of the capital instrument should provide that any redemption right should not be exercised unless and until the firm has given the notice to the FSA required under PRU 2.2.72 R.
(e) Any redemption right should not be exercisable unless both before and after the redemption the firm complies with PRU 2.1.9 R (which requires that a firm has sufficient capital resources to meet its capital resources requirement).

(2) Under PRU 2.2.70 R, a firm should not include a potential tier one instrument that is redeemable in whole or in part in permanent share capital in its tier one capital resources unless the firm has:

(a) sufficient permanent share capital or sufficient authority to issue permanent share capital (and the authority to allot it) to meet any redemption obligations that have become due; and
(b) a prudent reserve of permanent share capital or sufficient authority to issue permanent share capital (and the authority to allot it) to meet possible future redemption obligations.

(3) PRU 2.2.65 R contains limits on the amount of permanent share capital that may be issued on a redemption of a potential tier one instrument redeemable in permanent share capital.

31/10/2004

PRU 2.2.44

The rules defining whether a firm's potential tier one instruments are eligible for inclusion in its permanent share capital are to be found in PRU 2.2.36 R. As far as redemption is concerned, it says that the capital instrument should be no more capable of being redeemed than a share under the Companies Act 1985 or the Companies (Northern Ireland) Order 1986. PRU 2.2.38 R (which sets out the basic rules for redemption) does not apply to permanent share capital as a redeemable potential tier one instrument should not be included in permanent share capital.

31/10/2004

PRU 2.2.45

The rules about redemption that are relevant to deciding whether a firm's potential tier one instruments should be classified as innovative tier one instruments are as follows.

(1) Under PRU 2.2.53 R, a redeemable potential tier one instrument is always treated as an innovative tier one instrument if the redemption proceeds are payable otherwise than in cash.
(2) Under PRU 2.2.54 R, any feature of a tier one instrument that in conjunction with a call would make a firm more likely to redeem it or to have an incentive to do so will make it an innovative tier one instrument.
(3) Under PRU 2.2.62 R a step-up coupled with a right of redemption results in a potential tier one instrument being treated as an innovative tier one instrument.

31/10/2004

Further guidance on coupons

PRU 2.2.46

The rules in PRU 2.2 about the coupons payable on potential tier one instruments fall into the same three classes that apply to the rules on redemption, as set out in PRU 2.2.42 G.

31/10/2004

PRU 2.2.47

The rules about coupons that are relevant to deciding whether a firm's potential tier one instruments are eligible for inclusion in its tier one capital resources at all are as follows.

(1) Under PRU 2.2.29 R (4) and PRU 2.2.40 R, any deferred cumulative coupon should only be payable in permanent share capital. If a cumulative coupon is payable on a potential tier one instrument in another form, it should not be included in the firm's tier one capital resources.
(2) Under PRU 2.2.29 R (7), the firm has the right not to pay a coupon in cash at any time.
(3) PRU 2.2.63 R says that a potential tier one instrument that may be subject to a step-up that potentially exceeds defined limits should not be included in the firm's tier one capital resources. PRU 2.2.64 R says that any step-up should not arise before the tenth anniversary of the date of issue if it is to be included in the firm's tier one capital resources.
(4) The provisions of PRU 2.2.70 R summarised in PRU 2.2.43 G (2) also apply to the payment of coupons.

31/10/2004

PRU 2.2.48

PRU 2.2.36 R (2) says that a capital instrument on which a cumulative coupon is payable must not be included in a firm's permanent share capital. The payment of a coupon must be purely discretionary.

31/10/2004

PRU 2.2.49

The rules about coupons that are relevant to deciding whether a firm's potential tier one instruments should be classified as innovative tier one instruments are as follows:

(1) Under PRU 2.2.60 R a potential tier one instrument with a cumulative coupon is an innovative tier one instrument.
(2) Under PRU 2.2.40 R a potential tier one instrument with a coupon that if deferred must be paid in permanent share capital is an innovative tier one instrument.
(3) Under PRU 2.2.62 R a step-up coupled with a right of redemption by the firm results in a potential tier one instrument being treated as an innovative tier one instrument.

31/10/2004

Perpetual non-cumulative preference shares

PRU 2.2.50

A perpetual non-cumulative preference share may be included at stage B of the calculation in PRU 2.2.14 R if:

(1) it complies with PRU 2.2.29 R, PRU 2.2.35 R and PRU 2.2.38 R;
(2) any coupon on it is not cumulative, and the firm has the right to choose whether or not to pay a coupon in all circumstances;
(3) it is not excluded from tier one capital resources by any of the rules in PRU 2.2; and
(4) it is not an innovative tier one instrument.

31/10/2004

PRU 2.2.51

Perpetual non-cumulative preference shares should be perpetual and redeemable only at the firm's option. Any feature that, in conjunction with a call, would make a firm more likely to redeem perpetual non-cumulative preference shares would normally result in classification as an innovative tier one instrument. Such features would include, but not be limited to, a step-up, bonus coupon on redemption or redemption at a premium to the original issue price of the share.

31/10/2004

Innovative tier one instruments: general rules

PRU 2.2.52

If an item of capital is stated to be an innovative tier one instrument by the rules in PRU 2.2, it cannot be included in stages A or B of the calculation in PRU 2.2.14 R.

31/10/2004

PRU 2.2.53

If a tier one instrument is redeemable at the option of the firm, it is an innovative tier one instrument unless it is redeemable solely in cash.

31/10/2004

PRU 2.2.54

If a tier one instrument:

(1) is redeemable; and
(2) is issued on terms that are (or its terms are amended and the amended terms are) such that a reasonable person would (judging at or around the time of issue or amendment) think that:

(a) the firm is likely to redeem it; or
(b) the firm is likely to have a substantial economic incentive to redeem it;

that tier one instrument is an innovative tier one instrument.

31/10/2004

PRU 2.2.55

Any feature that in conjunction with a call would make a firm more likely to redeem a tier one instrument would normally result in classification as innovative tier one capital resources. Innovative tier one instruments include but are not limited to those incorporating a step-up or principal stock settlement.

31/10/2004

Innovative tier one instruments: loss absorbency

PRU 2.2.56

A capital instrument may only be included in innovative tier one capital resources if a firm's obligations under the instrument either:

(1) do not constitute a liability (actual, contingent or prospective) under section 123(2) of the Insolvency Act 1986; or
(2) do constitute such a liability but the terms of the instrument are such that:

(a) any such liability is not relevant for the purposes of deciding whether:

(i) the firm is, or is likely to become, unable to pay its debts; or
(ii) its liabilities exceed its assets;

(b) a creditor (including, but not limited to, a holder of the instrument) is not able to petition for the winding up or administration of the firm on the grounds that the firm is or may become unable to pay any such liability; and
(c) the firm is not obliged to take into account such a liability for the purposes of deciding whether or not the firm is, or may become, insolvent for the purposes of section 214 of the Insolvency Act 1986 (wrongful trading).

31/10/2004

PRU 2.2.57

The effect of PRU 2.2.56 R is that if a potential tier one instrument does constitute a liability, this should only be the case when the firm is able to pay that liability but chooses not to do so. As tier one capital resources must be undated, this will generally only be relevant on a solvent winding up of the firm.

31/10/2004

PRU 2.2.58

A firm wishing to issue an innovative tier one instrument must obtain an opinion from Queen's Counsel, or where the opinion relates to the law of a jurisdiction outside the United Kingdom, from a lawyer in that jurisdiction of equivalent status, confirming that the criteria in PRU 2.2.29 R (5) and PRU 2.2.31 R are met.

31/10/2004

PRU 2.2.59

The holder should agree that the firm has no liability (including any contingent or prospective liability) to pay any amount to the extent to which that liability would cause the firm to become insolvent if it made the payment or to the extent that its liabilities exceed its assets or would do if the payment were made. The terms of the capital instrument should be such that the directors can continue to trade in the best interests of the senior creditors even if this prejudices the interests of the holders of the instrument.

31/10/2004

Innovative tier one instruments: Coupons

PRU 2.2.60

A tier one instrument with a cumulative coupon which complies with PRU 2.2.40 R is an innovative tier one instrument.

31/10/2004

PRU 2.2.61

An item of capital does not fall into PRU 2.2.60 R merely because a firm has come under an obligation to pay a particular coupon in permanent share capital where that obligation is the result of a voluntary election by the holder or the firm to be paid the coupon in that form. Thus, for example, if a shareholder of a firm is allowed to elect to be paid a dividend in the form of a conventional scrip dividend, that does not make the share into an innovative tier one instrument.

31/10/2004

Innovative tier one instruments and other tier one instruments: step-ups

PRU 2.2.62

If:

(1) a potential tier one instrument is or may become subject to a step-up; and
(2) that potential tier one instrument is redeemable at any time (whether before, at or after the time of the step-up);

that potential tier one instrument is an innovative tier one instrument.

31/10/2004

PRU 2.2.63

If a potential tier one instrument is or may become subject to a step-up, a firm must not include it in its tier one capital resources if the amount of the step-up exceeds or may exceed;

(1) 100 basis points; and
(2) 50% of the initial credit spread.

31/10/2004

PRU 2.2.64

A firm must not include a potential tier one instrument that is or may become subject to a step-up in its tier one capital resources if the step-up can arise earlier than the tenth anniversary of the date of issue of that item of capital.

31/10/2004

Innovative tier one instruments: principal stock settlement

PRU 2.2.65

A firm must not include a potential tier one instrument that is redeemable in whole or in part in permanent share capital in its tier one capital resources if:

(1) the conversion ratio as at the date of redemption may be greater than the conversion ratio as at the time of issue by more than 200%; or
(2) the issue or market price of the conversion instruments issued in relation to one unit of the original capital item (plus any cash element of the redemption) may be greater than the issue price (or, as the case may be, market price) of that original capital item.

31/10/2004

PRU 2.2.66

In PRU 2.2.65 R to PRU 2.2.69 R:

(1) the original capital item means the capital item that is being redeemed; and
(2) the conversion instrument means the permanent share capital issued on its redemption.

31/10/2004

PRU 2.2.67

In PRU 2.2.65 R to PRU 2.2.69 R, the conversion ratio means the ratio of:

(1) the number of units of the conversion instrument that the firm must issue to satisfy its redemption obligation (so far as it is to be satisfied by the issue of conversion instruments) in respect of one unit of the original capital item; to
(2) one unit of the original capital item.

31/10/2004

PRU 2.2.68

In PRU 2.2.65 R, the conversion ratio as at the date of issue of the original capital item is calculated as if the original capital item were redeemable at that time.

31/10/2004

PRU 2.2.69

If the conversion instruments or the original capital item are subdivided or consolidated or subject to any other occurrence that would otherwise result in like not being compared with like, the conversion ratio calculation in PRU 2.2.65 R must be adjusted accordingly.

31/12/2004

Requirement to have sufficient unissued stock

PRU 2.2.70

(1) This rule applies to a potential tier one instrument of a firm where either:

(a) the redemption proceeds; or
(b) any coupon on that capital item;

can be satisfied by the issue of another tier one instrument.
(2) A firm may only include an item of capital to which this rule applies in its tier one capital resources if the firm has authorised and unissued tier one instruments of the kind in question (and the authority to issue them):

(a) that are sufficient to satisfy all such payments then due; and
(b) are of such amount as is prudent in respect of such payments that could become due in the future.

31/10/2004

Notifying the FSA of the issue and redemption of tier one instruments

PRU 2.2.71

A firm must not include any perpetual non-cumulative preference shares or innovative tier one instruments in its tier one capital resources for the purpose of PRU 2.2 unless it has notified the FSA of its intention at least one month before it first includes them.

31/10/2004

PRU 2.2.72

A firm must not redeem any tier one instrument that it has included in its tier one capital resources for the purpose of PRU 2.2 unless it has notified the FSA of its intention at least one month before it does so.

31/12/2004

Non standard capital instruments

PRU 2.2.73

There may be examples of capital instruments that, although based on a standard form, contain structural features that make the rules in PRU 2.2 difficult to apply. In such circumstances, a firm may seek individual guidance on the application of those rules to the capital instrument in question. See SUP 9 for the process to be followed when seeking individual guidance.

31/10/2004

Step-ups

PRU 2.2.74

In relation to a tier one instrument, a step-up means any change in the coupon rate on that instrument that results in an increase in the amount payable at any time, including a change already provided in the original terms governing those payments. A step-up:

(1) includes (in the case of a fixed rate) an increase in that coupon rate;
(2) includes (in the case of a floating rate calculated by adding a fixed amount to a fluctuating amount) an increase in that fixed amount;
(3) includes (in the case of a floating rate) a change in the identity of the benchmark by reference to which the fluctuating element of the coupon is calculated that results in an increase in the absolute amount of the coupon;
(4) does not include (in the case of a floating rate) an increase in the absolute amount of the coupon caused by fluctuations in the fluctuating figure by reference to which the absolute amount of the coupon floats.

31/10/2004

PRU 2.2.75

Where a rule in PRU 2.2 says that a particular treatment applies to an item of capital that is subject to a step-up of a specified amount, the question of whether that rule is satisfied must be judged by reference to the cumulative amount of all step-ups since the issue of that item of capital rather than just by reference to a particular step-up.

31/10/2004

Profit and loss account and other reserves

PRU 2.2.76

Negative amounts, including any interim net losses, must be deducted from tier one capital resources.

31/10/2004

PRU 2.2.77

Dividends must be deducted from reserves as soon as they are declared.

31/10/2004

Valuation differences

PRU 2.2.78

Valuation differences are all differences between the valuation of assets and liabilities as valued in PRU and the valuation that the firm uses for its external financial reporting purposes, except valuation differences which are dealt with elsewhere in PRU 2.2.14 R. The sum of these valuation differences must either be added to (if positive) or deducted from (if negative) a firm's capital resources in accordance with PRU 2.2.14 R.

31/10/2004

PRU 2.2.79

Additions to and deductions from capital resources will arise from the application of asset and liability valuation and admissibility rules (see PRU 1.3, PRU 2.2.86 R and PRU 2 Annex 1R). Downward adjustments include discounting of technical provisions for general insurance business (which is optional for financial reporting but not permitted for regulatory valuation - see PRU 2.2.80 R to PRU 2.2.81 R) . Details of valuation differences relating to technical provisions and liability adjustments for long-term insurance business are set out in PRU 7.3. In particular, contingent loans or other arrangements which are not valued as a liability under PRU 7.3.79R (2) result in a positive valuation difference.

31/10/2004

PRU 2.2.80

PRU 2.2.81 R applies to a firm that carries on general insurance business, except a pure reinsurer, and which discounts or reduces its technical provisions for claims outstanding to take account of its investment income as permitted by Article 60(1)(g) of the Annual Accounts Directive.

31/10/2004

PRU 2.2.81

A firm of a kind referred to in PRU 2.2.80 R must deduct from its capital resources the difference between the undiscounted technical provisions or technical provisions before deductions as disclosed in the notes on the accounts, and the discounted technical provisions or technical provisions after deductions. This adjustment must be made for all general insurance business classes, except for risks listed under classes 1 and 2. For classes other than 1 and 2, no adjustment needs to be made in respect of the discounting of annuities included in technical provisions.

31/10/2004

Externally verified interim net profits

PRU 2.2.82

Externally verified interim net profits are interim profits verified by a firm's external auditors after deduction of tax, declared dividends and other appropriations.

31/10/2004

PRU 2.2.83

The FSA may request a firm to provide it with a copy of the external auditor's opinion on whether the interim profits are fairly stated.

31/10/2004

Intangible assets

PRU 2.2.84

A firm must deduct from its tier one capital resources the value of intangible assets.

31/10/2004

PRU 2.2.85

Intangible assets include goodwill, capitalised development costs, brand names, trademarks and similar rights, and licences.

31/10/2004

Inadmissible assets

PRU 2.2.86

For the purposes of PRU 2.2.14 R, a firm must deduct from total capital resources the value of any asset which is not an admissible asset as listed in PRU 2 Annex 1 R.

31/10/2004

PRU 2.2.87

PRU 2.2.86 R does not apply to intangible assets which must be deducted from tier one capital resources under PRU 2.2.84 R.

31/10/2004

PRU 2.2.88

The list of admissible assets has been drawn with the aim of excluding assets:

(1) for which a sufficiently objective and verifiable basis of valuation does not exist; or
(2) whose realisability cannot be relied upon with sufficient confidence; or
(3) whose nature presents an unacceptable custody risk; or
(4) the holding of which may give rise to significant liabilities or onerous duties.

31/10/2004

Adjustments for related undertakings

PRU 2.2.89

A firm must deduct from its capital resources the value of its investments in each of its related undertakings that is an ancillary services undertaking.

31/10/2004

PRU 2.2.90

In relation to each of its related undertakings that is a regulated related undertaking (other than an insurance undertaking) a firm must add to (if positive), at stage J in PRU 2.2.14 R, or deduct from (if negative), at stage L in PRU 2.2.14 R, its capital resources the value of its shares in that undertaking calculated in accordance with PRU 1.3.35 R.

31/10/2004

PRU 2.2.91

For the purposes of PRU 2.2.89 R, investments must be valued at their accounting book value in accordance with PRU 1.3.5 R.

31/10/2004

PRU 2.2.92

Related undertakings which are also insurance undertakings are not included in PRU 2.2.90 R because a firm that is a participating insurance undertaking is subject to the requirements of PRU 8.3.

31/10/2004

Additional requirements for a tier one or tier two instrument issued by a firm carrying on with-profits insurance business

PRU 2.2.93

A firm carrying on with-profits insurance business must, in addition to the other requirements in respect of capital resources elsewhere in PRU 2.2, meet the following conditions before a capital instrument can be included in the firm's capital resources:

(1) the firm must manage the with-profits fund so that discretionary benefits under a with-profits insurance contract are calculated and paid disregarding, insofar as is necessary for its customers to be treated fairly, any liability the firm may have to make payments under the capital instrument;
(2) the intention to manage the with-profits fund on the basis set out in PRU 2.2.93 R (1) must be disclosed in the firm's Principles and Practices of Financial Management; and
(3) no amounts, whether interest, principal, or other amounts, must be payable by the firm under the capital instrument if the firm's assets would then be insufficient to enable it to declare and pay under a with-profits insurance contract discretionary benefits that are consistent with the firm's obligations under Principle 6.

31/10/2004

PRU 2.2.94

The purpose of PRU 2.2.93 R is to achieve practical subordination of capital instruments if they are to qualify as capital resources to the liabilities a firm has to with-profits policyholders, including liabilities which arise from the regulatory duty to treat customers fairly in setting discretionary benefits. (Principle 6 (Customers' interests) requires a firm to pay due regard to the interests of its customers and treat them fairly.) It is not sufficient for a capital instrument to be subordinated to such liabilities only on winding up of the firm because such liabilities to policyholders may have been reduced by the inappropriate use of management discretion to enable funds to be applied in repaying subordinated capital instruments before winding up proceedings commence.

31/10/2004

PRU 2.2.95

PRU 2.2.93 R is an additional requirement to all other rules in PRU 2.2 concerning the eligibility of a capital instrument to count as a component of a firm's capital resources. Subordinated debt instruments will be the main type of capital instrument to which this rule is relevant, including both upper tier two (undated) and lower tier two (dated) subordinated debt instruments. Subordinated debt instruments which are issued by a related undertaking are not intended to be covered by this rule and may be included in group capital resources as appropriate if the other eligibility criteria are met.

31/10/2004

PRU 2.2.96

PRU 2.2.29 R (8) and PRU 2.2.108 R (10) contain provisions concerning the marketing of a capital instrument. In relation to a firm to which PRU 2.2.93 R applies, in order to comply with PRU 2.2.29 R (8) and PRU 2.2.108 R (10), it should draw to the attention of subscribers the risk that payments may be deferred or cancelled in order to operate the with-profits fund so as to give priority to the payment of discretionary benefits to with-profits policyholders.

31/10/2004

PRU 2.2.97

(1) Upper tier two instruments must meet the requirements of PRU 2.2.101 R (3) which goes beyond the requirement in PRU 2.2.93 R (3) since it requires a firm to have the option to defer payments in all circumstances, not just if necessary to treat customers fairly. However, for lower tier two instruments, PRU 2.2.93 R (3) represents an additional requirement since a failure to pay amounts of interest or principal on a due date must not constitute an event of default under PRU 2.2.108 R (2) for firms carrying on with-profits insurance business.
(2) For firms which are realistic basis life firms compliance with PRU 2.2.93 R (3) would usually be achieved if the capital instrument provides that no amounts will be payable under it unless the firm's capital resources exceed its capital resources requirement. However, such firms should ensure that the terms of the capital instrument refer to FSA capital resources requirements in force from time to time, including the current realistic reserving requirements and are not restricted to former minimum capital requirements based only on the Insurance Directives' required minimum margin of solvency. For firms which are not realistic basis life firms, compliance with PRU 2.2.93 R (3) will probably require specific reference to be made to treating customers fairly in the terms of the capital instrument.

31/10/2004

Tier two capital

PRU 2.2.98

Tier two capital resources is split into upper and lower tiers. The principal distinction between upper and lower tier two capital is that perpetual instruments may be included in upper tier two capital whereas dated instruments, such as fixed term preference shares and dated subordinated debt, are included in lower tier two capital.

31/10/2004

PRU 2.2.99

Tier two capital instruments are capital instruments that combine the features of debt and equity in that they are structured like debt, but exhibit some of the loss absorption and funding flexibility features of equity.

31/10/2004

Upper tier two capital

PRU 2.2.100

Examples of capital instruments which may be eligible to count in upper tier two capital resources include the following:

(1) perpetual cumulative preference shares;
(2) perpetual subordinated debt; and
(3) other instruments that have the same economic characteristics as (1) or (2).

31/10/2004

PRU 2.2.101

A capital instrument must meet the following conditions before it can be included in a firm's upper tier two capital resources:

(1) it must meet the general conditions described in PRU 2.2.108 R;
(2) it must have no fixed maturity date;
(3) the contractual terms of the instrument must provide for the firm to have the option to defer any interest payment in cash on the debt; and
(4) the contractual terms of the instrument must provide for the loss-absorption capacity of the debt and unpaid interest, whilst enabling the firm to continue its business.

31/10/2004

PRU 2.2.102

A capital instrument does not meet PRU 2.2.101 R (4) unless it meets PRU 2.2.103 R and PRU 2.2.105 R.

31/10/2004

PRU 2.2.103

A capital instrument may only be included in upper tier two capital resources if a firm's obligations under the instrument either:

(1) do not constitute a liability (actual, contingent or prospective) under section 123(2) of the Insolvency Act 1986; or
(2) do constitute such a liability but the terms of the instrument are such that:

(a) any such liability is not relevant for the purposes of deciding whether:

(i) the firm is, or is likely to become, unable to pay its debts; or
(ii) its liabilities exceed its assets;

(b) a creditor (including but not limited to a holder of the instrument) is not able to petition for the winding up or administration of the firm on the grounds that the firm is or may become unable to pay any such liability; and
(c) the firm is not obliged to take into account such a liability for the purposes of deciding whether or not the firm is, or may become, insolvent for the purposes of section 214 of the Insolvency Act 1986 (wrongful trading).

31/10/2004

PRU 2.2.104

The effect of PRU 2.2.103 R is that if an upper tier two instrument does constitute a liability, this should only be the case when the firm is able to pay that liability but chooses not to do so. As upper tier two capital resources must be undated, this will generally only be relevant on a solvent winding up of the firm.

31/10/2004

PRU 2.2.105

A firm wishing to issue an upper tier two instrument other than a perpetual cumulative preference share must obtain an opinion from Queen's Counsel, or where the opinion relates to the law of a jurisdiction outside the United Kingdom, from a lawyer in that jurisdiction of equivalent status, confirming that the criteria in PRU 2.2.101 R (4) are met.

31/10/2004

PRU 2.2.106

For the purpose of PRU 2.2.103 R (2)(b) above, the holder should agree that the firm has no liability (including any contingent or prospective liability) to pay any amount to the extent to which that liability would cause the firm to become insolvent if it made the payment or to the extent that its liabilities exceed its assets or would do if the payment were made. The terms of the capital instrument should be such that the directors can continue to trade in the best interests of the senior creditors even if this prejudices the interests of the holders of the instrument.

31/10/2004

Lower tier two capital

PRU 2.2.107

Capital instruments that meet the general conditions described in PRU 2.2.108 R may be included in lower tier two capital resources.

31/10/2004

General conditions for eligibility as tier two capital

PRU 2.2.108

A capital instrument must not form part of the tier two capital resources of a firm unless it meets the following conditions:

(1) the claims of the creditors must rank behind those of all unsubordinated creditors;
(2) the only events of default must be non-payment of any amount falling due under the terms of the capital instrument or the winding-up of the firm;
(3) the remedies available to the subordinated creditor in the event of non-payment or other breach of the written agreement or instrument must be limited to petitioning for the winding-up of the firm or proving for the debt and claiming in the liquidation of the firm;
(4) any events of default and any remedy described in (3) must not prejudice the matters in (1) and (2);
(5) in addition to the requirement about repayment in (1), the debt must not become due and payable before its stated final maturity date (if any) except on an event of default complying with (2);
(6) the debt agreement or terms of the capital instrument are governed by the law of England and Wales, or of Scotland or of Northern Ireland;
(7) to the fullest extent permitted under the laws of the relevant jurisdictions, creditors must waive their right to set off amounts they owe the firm against subordinated amounts included in the firm's capital resources owed to them by the firm;
(8) the terms of the capital instrument must be set out in a written agreement that contains terms that provide for the conditions set out in (1) to (7);
(9) the debt must be unsecured and fully paid up;
(10) the description of its characteristics used in its marketing is consistent with the characteristics required to satisfy (1) to (9); and
(11) the firm has obtained a properly reasoned external legal opinion stating that the requirements in (1) to (10) have been met.

31/12/2004

PRU 2.2.109

For the purposes of PRU 2.2.108 R (5) the debt agreement or terms of the instrument should not contain any clause which might require early repayment of the debt (e.g. cross default clauses, negative pledges and restrictive covenants). A cross default clause is a clause which says that the loan goes into default if any of the borrower's other loans go into default. It is intended to prevent one creditor being repaid before other creditors, e.g. obtaining full repayment through the courts. A negative pledge is a clause which puts the loan into default if the borrower gives any further charge over its assets. A restrictive covenant is a term of contract that directly, or indirectly, could lead to early repayment of the debt. Some covenants, e.g. relating to the provision of management information or ownership restrictions, are likely to comply with PRU 2.2.108 R (5) as long as monetary redress is ruled out, or any payments are covered by the subordination and limitation of remedies clauses (that is, if damages are unpaid, the only remedy is to petition for a winding up).

31/10/2004

PRU 2.2.110

The purpose of PRU 2.2.108 R (7) is to ensure that all of the firm's assets are available to customers ahead of subordinated creditors. The waiver should apply both before and during liquidation.

31/10/2004

PRU 2.2.111

PRU 2.2.108 R (6) does not apply if the firm has obtained a properly reasoned external legal opinion confirming that the same degree of subordination has been achieved under the law that governs the debt and the agreement as that which would have been achieved under the laws of England and Wales, Scotland, or Northern Ireland.

31/10/2004

PRU 2.2.112

An item of capital does not comply with PRU 2.2.108 R (10) if it is marketed as a capital instrument that would only qualify for a lower level of capital or on the basis that investing in it is like investing in a lower tier capital instrument. For example, an undated capital instrument should not be marketed as a dated capital instrument if the terms of the capital instrument include an option by the issuer to redeem the capital instrument at a specified date in the future.

31/10/2004

PRU 2.2.113

(1) An item of capital does not comply with PRU 2.2.101 R or PRU 2.2.108 R if the issue of that item of capital by the firm is connected with one or more other transactions which, when taken together with the issue of that item, could produce the effect described in (2).
(2) The effect referred to in (1) is a reduction in the economic benefit intended to be conferred on the firm by the issue of the item of capital which means that the item of capital no longer displays all of the characteristics set out in PRU 2.2.101 R or PRU 2.2.108 R.

31/10/2004

PRU 2.2.114

For the purposes of PRU 2.2.113 R, examples of connected transactions might include guarantees or any other side agreement provided to the holders of the capital instrument by the firm or a connected party or a related transaction designed, for example, to enhance their security or to achieve a tax benefit, but which may compromise the loss absorption capacity or permanence of the original capital item.

31/10/2004

PRU 2.2.115

The FSA is more concerned that the subordination provisions listed in PRU 2.2.108 R should be effective than that they should follow a particular form. The FSA does not, therefore, prescribe that the loan agreement should be drawn up in a standard form.

31/12/2004

PRU 2.2.116

A firm must not amend the terms of the debt and the documents referred to in PRU 2.2.108 R (8) unless:

(1) at least one month before the amendment is due to take effect, the firm has given the FSA notice in writing of the proposed amendment and the FSA has not objected; and
(2) that notice includes confirmation that the legal opinions referred to in PRU 2.2.108 R (11) and, if applicable, PRU 2.2.105 R and PRU 2.2.111 R, continue in full force and effect in relation to the terms of the debt and documents, notwithstanding any proposed amendment.

31/10/2004

PRU 2.2.117

A firm must notify the FSA of its intention to repay a tier two instrument at least six months before the date of the proposed repayment (unless the firm intends to repay an instrument on its contractual repayment date) providing details of how it will meet its capital resources requirement after such repayment.

31/10/2004

Step-ups

PRU 2.2.118

In relation to a tier two instrument, a step-up in a coupon rate means:

(1) (in the case of a fixed rate) an increase in that rate;
(2) (in any other case) any change in the way that the interest or other payment is calculated that may result in an increase in the amount payable at any time, including a change already provided in the original terms governing those payments.

31/10/2004

PRU 2.2.119

Where a tier two instrument is subject to one or more step-ups, the first date that a step-up can take effect must be treated, for the purposes of this section, as the instrument's final maturity date if its actual maturity date occurs after that, unless the effect of the step-up or step-ups is to increase the coupon rate at which payments are to be made by no more than:

(1) 50 basis points in the first ten years of the life of the debt; or
(2) 100 basis points over the whole life of the debt.

31/10/2004

PRU 2.2.120

A firm may not include in its tier two capital resources a capital instrument the terms of which provide for a step-up in the first five years after issue.

31/10/2004

PRU 2.2.121

Where a step-up arises through a change from paying a coupon on a debt instrument to paying a dividend on a share issued in settlement of the coupon, then any cost to the firm arising from the tax treatment of the dividend may be excluded.

31/10/2004

PRU 2.2.122

Debt instruments containing embedded options, e.g. issues containing options for the interest rate after the step-up to be at a margin over the higher of two (or more) reference rates, or for the interest rate in the previous period to act as a floor, may affect the funding costs of the borrower and imply a step-up. In such circumstances, a firm may wish to seek individual guidance on the application of the rules relating to step-ups to the capital instrument in question. See SUP 9 for the process to be followed when seeking individual guidance.

31/10/2004

PRU 2.2.123

A capital instrument may be included in lower tier two capital resources only if it has an original maturity of at least five years or, where it has no fixed maturity date, notice of repayment of not less than five years has been given.

31/10/2004

PRU 2.2.124

In its final five years to maturity, for the purposes of calculating the amount of a lower tier two instrument which may be included in a firm's capital resources, the principal amount must be amortised on a straight line basis.

31/10/2004

PRU 2.2.125

PRU 2.2.124 R applies both to a tier two instrument with a fixed maturity and to a tier two instrument with no fixed maturity but where the firm has given five years' notice of repayment.

31/10/2004

Unpaid share capital or initial funds and calls for supplementary contributions

PRU 2.2.126

Unpaid share capital or, in the case of a mutual, unpaid initial funds and calls for supplementary contributions are excluded from the capital resources of a firm except to the extent allowed in a waiver under section 148 of the Act.

31/10/2004

PRU 2.2.127

Subject to a waiver, under the Insurance Directives a maximum of one half of unpaid share capital or, in the case of a mutual, one half of the unpaid initial fund may be included in a firm's capital resources, once the paid-up part amounts to 25% of that share capital or fund, up to 50% of total capital resources.

31/12/2004

PRU 2.2.128

In the case of a mutual carrying on general insurance business and subject to a waiver, calls for supplementary contributions within the financial year may only be included in a firm's capital resources up to a maximum of 50% of the difference between the maximum contributions and the contributions actually called in, subject to a limit of 50% of total capital resources. In the case of a mutual carrying on long-term insurance business, the Consolidated Life Directive does not permit calls for supplementary contributions to be included in a firm's capital resources.

31/10/2004

PRU 2.3

Individual Capital Assessment

31/12/2004

Application

PRU 2.3.1

PRU 2.3 applies to an insurer unless it is:

(1) a non-directive friendly society; or
(2) a Swiss general insurer; or
(3) an EEA-deposit insurer; or
(4) an incoming EEA firm; or
(5) an incoming Treaty firm.

31/12/2004

Purpose

PRU 2.3.2

Principle 4 requires a firm to maintain adequate financial resources. PRU 2 sets out provisions that deal specifically with the adequacy of that part of a firm's financial resources that consists of capital resources. The adequacy of a firm's capital resources needs to be assessed both by the firm and the FSA. In PRU 2.1, the FSA sets minimum capital resources requirements for firms. It also reviews a firm's own assessment of its capital needs, and the processes and systems by which that assessment is made, in order to see if the minimum capital resources requirements are appropriate. PRU 1.2 contains rules requiring a firm to identify and assess risks to its being able to meet its liabilities as they fall due, to assess how it intends to deal with those risks and to quantify the financial resources it considers necessary to mitigate those risks. To meet these requirements, a firm should consider the extent to which capital is an appropriate mitigant for the risks identified and assess the amount and quality of capital required. In accordance with PRU 1.2.37 R, these assessments must be documented so that they can be easily reviewed by the FSA as part of the FSA's assessment of the adequacy of the firm's capital resources.

31/12/2004

PRU 2.3.3

This section (PRU 2.3) sets out guidance on how firms should assess the adequacy of their capital resources, both to comply with the rules in PRU 1.2 and to enable the FSA better to assess whether the minimum capital resources requirements in PRU 2.1 are appropriate. This section also requires firms carrying on general insurance business to calculate their ECR. The ECR for firms carrying on general insurance business is an indicative measure of the capital resources that a firm may need to hold based on risk sensitive calculations applied to its business profile. For realistic basis life firms, the ECR forms part of the calculation of the firm's capital resources requirement (see PRU 2.1.15 R). The ECR for such firms requires the calculation of a with-profits insurance capital component (see PRU 7.4) that supplements the mathematical reserves so as to ensure that a firm holds adequate financial resources for the conduct of its with-profits insurance business. In the case of firms carrying on general insurance business and realistic basis life firms, the FSA will use the ECR as a benchmark for its consideration of the appropriateness of the firm's own capital assessment. For firms where an ECR is not calculated the MCR will provide a benchmark for the firm's own capital assessment. For firms generally, the more thorough, objective and prudent a firm's capital assessment is and can be demonstrated as being, the more reliance the FSA will be able to place on the results of that assessment. The FSA will consider the appropriateness of the firm's capital assessment to establish the level of capital resources the firm needs. This may result in the FSA's assessment of a firm's capital resources needs being lower or higher than would otherwise be the case.

31/12/2004

PRU 2.3.4

There are two main purposes of this section:

(1) to enable firms to understand the issues which the FSA would expect to see assessed and the systems and processes which the FSA would expect to see in operation for capital adequacy assessments by the firm to be regarded as thorough, objective and prudent; and
(2) to enable firms to understand the FSA's approach to assessing whether the minimum capital resources requirements of PRU 2.1 are appropriate and what action may be taken if the FSA concludes that those requirements are not appropriate to a firm's circumstances.

31/12/2004

Main requirements and guidance

PRU 2.3.5

In making an assessment of capital adequacy, the FSA requires firms to identify the major risks they face and, where capital is appropriate to mitigate those risks, to quantify how much (and what type) of capital is appropriate. To do this, the FSA expects firms to conduct stress tests and scenario analyses in respect of each risk. For each risk the firm will then be able to estimate a range of probable outcomes and hence capital required to absorb losses which might arise. A firm must document the results of each of the stress tests and scenario analyses undertaken and should also document, as part of the details of those tests and analyses, the key assumptions including the aggregation of the results.

31/12/2004

PRU 2.3.6

The assessment which a firm makes should be based upon its future business plans and projections. This is the main area where the firm's assessment may diverge from its prescribed capital resources requirement which, necessarily, is based upon historic data.

31/12/2004

PRU 2.3.7

In assessing the quality and the amount of capital resources projected to be available to meet its projected capital resources requirement, a firm should consider the timing of its liabilities to repay existing capital together with the prospects for raising new capital in the scenarios considered.

31/12/2004

PRU 2.3.8

The FSA may ask for the results of a firm's assessment to be provided to it together with a description of the processes by which the assessment has been made, the range of results from each stress test or scenario analysis performed and the main assumptions made. The FSA may also carry out a more detailed examination of the details of the firm's processes and calculations.

31/12/2004

PRU 2.3.9

Based upon this information and other information available to the FSA, the FSA will consider whether the capital resources requirement applicable to the firm is appropriate. Where relevant, the firm's ECR will be a key input to the FSA's assessment of the adequacy of the firm's capital resources.

31/12/2004

PRU 2.3.10

A firm carrying on general insurance business, other than a non-directive insurer, must calculate the amount of its ECR.

31/12/2004

PRU 2.3.11

A firm to which PRU 2.3.10 R applies must calculate its ECR in respect of its general insurance business as the sum of:

(1) the asset-related capital requirement; and
(2) the insurance-related capital requirement; less
(3) the firm's equalisation provisions.

31/12/2004

PRU 2.3.12

Details of the calculation of the asset-related capital requirement are set out in PRU 3.3.10 R to PRU 3.3.16 R. Details of the calculation of the insurance-related capital requirement are set out in PRU 7.2.76 R to PRU 7.2.79 R.

31/12/2004

PRU 2.3.13

Where the FSA considers that a firm will not comply with PRU 1.2.22 R (adequate financial resources, including capital resources) by holding the capital resources required by PRU 2.1, the FSA may give the firm individual guidance advising it of the amount and quality of capital resources which the FSA considers it needs to hold in order to meet that rule.

31/12/2004

PRU 2.3.14

The individual guidance will be given taking into consideration capital resources consistent with a 99.5% confidence level over a one year timeframe or, if appropriate to the firm's business, an equivalent lower confidence level over a longer timeframe. Firms should therefore prepare an individual capital assessment on the same basis. Throughout whatever timeframe is adopted by firms, firms should ensure that their projected assets are, and will continue to be, sufficient, to enable their projected liabilities to be paid, and it would be reasonable for firms to test that this is the case at the end of each year of the timeframe. Firms may also wish to make estimates of capital adequacy using other assumptions for their own internal purposes and are free to do so if they so choose.

31/12/2004

PRU 2.3.15

If a firm considers that the individual guidance is inappropriate to its circumstances, then the firm should inform the FSA that it does not intend to follow that guidance. Informing the FSA of such an intention would be expected if a firm is to comply with Principle 11 (relations with regulators).

31/12/2004

PRU 2.3.16

The FSA expects most disagreements about the adequacy of capital will be resolved through further analysis and discussion. The FSA may consider the use of its powers under section 166 of the Act (Reports by skilled persons) to assist in such circumstances. If the FSA and the firm still do not agree on an adequate level of capital, then the FSA may consider using its powers under section 45 of the Act to, on its own initiative, vary a firm's Part IV permission so as to require it to hold capital in accordance with the FSA's view of the capital necessary to comply with PRU 1.2.22 R. SUP 7 provides further information about the FSA's powers under section 45.

31/12/2004

PRU 2.3.17

Where a firm or the FSA considers that the capital resources requirements of PRU 2.1 require the holding of more capital than is needed for the firm to comply with PRU 1.2.22 R then the firm may apply to the FSA for a waiver of the requirements in PRU 2.1 under section 148 of the Act. This section sets out the factors which the FSA will consider in deciding whether to grant such a waiver request, and if so, the terms and extent of any modification to the rules in PRU 2.1. In addition to the statutory tests under section 148, these will include the thoroughness, objectivity, and prudence of a firm's own capital assessment and the extent to which the guidance in this section has been followed. The FSA will not grant a waiver that would cause a breach of the minimum capital requirements under the Insurance Directives.

31/12/2004

Stress and scenario requirement

PRU 2.3.18

PRU 1.2.35 R requires a firm to carry out stress tests and scenario analyses for each of the sources of risk identified in accordance with PRU 1.2.31 R. Using each of the risk categories set out in PRU 1.2.31 R, PRU 2.3.19 G to PRU 2.3.34 G set out the factors that a firm should consider. PRU 2 Ann 3 G provides a practical illustration of how a small firm carrying on general insurance business might undertake this analysis.

31/12/2004

Factors to consider when assessing credit risk

PRU 2.3.19

Credit risk refers to the risk of loss if another party fails to perform its obligations or fails to perform them in a timely fashion.

31/12/2004

PRU 2.3.20

In assessing potential credit risk events that may affect the firm's solvency, a firm should allow for:

(1) the financial effect of non-payment of reinsurance, considering the likelihood both of non-payment of outstanding claims and for the fact that reinsurance cover purchased for underwritten risks may not be effective (that is, offsetting potential liabilities); and
(2) the financial effect of non-payment of premium debtors such as intermediaries and policyholders.

31/12/2004

PRU 2.3.21

Some further areas to consider in developing the credit risk stress tests and scenario analyses might include:

(1) the adequacy of the reinsurance programme and whether it is appropriate for the risks selected by the firm and adequately takes account of the underwriting and business plans of the firm generally;
(2) the collapse of a reinsurer or several reinsurers on the firm's reinsurance programme and the subsequent impact this may have on the firm's outstanding reinsurance recoveries and IBNR recoveries;
(3) a deterioration in the creditworthiness of the firm's reinsurers, intermediaries or other counterparties;
(4) the degree of credit concentration. For example, the degree to which a firm is exposed to a single counterparty or group;
(5) the degree of concentration of exposure to reinsurers of particular rating grades;
(6) the prospect of reinsurance rates increasing substantially or reinsurance being unavailable;
(7) any existing or possible future disputes relating to reinsurance contracts on a pessimistic basis and the extent that they are not already reflected in the value attributed to the reinsurances;
(8) greater losses from bad debts than anticipated;
(9) deterioration in the extent and quality of collateral; and
(10) guarantees given by the insurer of the performance of others, whether under contracts of insurance or otherwise.

31/12/2004

Factors to consider when assessing market risk

PRU 2.3.22

Market risk includes the risks that arise from fluctuations in values of, or income from, assets or in interest or exchange rates.

31/12/2004

PRU 2.3.23

In assessing potential market risk events that may affect the firm's solvency, a firm should allow for:

(1) reduced market values of investments;
(2) variation in interest rates and the effect on the market value of investments;
(3) a lower level of investment income than planned; and
(4) the possibility of counterparty defaults.

31/12/2004

PRU 2.3.24

Some further areas to consider in developing the market risk scenario might include:

(1) the possibility of a severe economic or market downturn or upturn leading to adverse interest rate movements affecting the firm's investment position;
(2) unanticipated losses and defaults of issuers;
(3) price shifts in asset classes, and their impact on the entire portfolio;
(4) inadequate valuation of assets;
(5) the direct impact on the portfolio of currency devaluation, as well as the effect on related markets and currencies;
(6) extent of any mismatch of assets and liabilities, including reinvestment risk;
(7) the impact on the portfolio value of a dramatic change in the spread between a market index of interest rates and the risk-free interest rates; and
(8) the extent to which market moves could have non-linear effects on values, such as derivatives.

31/12/2004

Factors to consider when assessing liquidity risk

PRU 2.3.25

In accordance with PRU 1.2.31 R a firm should consider the major sources of risk, including liquidity risks, and assess its response should each risk materialise.

31/12/2004

PRU 2.3.26

PRU 5.1 (liquidity risk systems and controls) contains evidential provisions and guidance on how firms should meet PRU 1.2.22 R for liquidity purposes.

(1) PRU 5.1.61 E states that a scenario analysis in relation to liquidity risk required under PRU 1.2.35 R should include a cash-flow projection for each scenario tested, based on reasonable estimates of the impact of that scenario on the firm's funding needs and sources.
(2) PRU 5.1.86 E states that a firm should have a contingency funding plan for taking action to ensure, so far as it can, that in each of the scenarios tested under PRU 1.2.35R (2), it would still have sufficient liquid financial resources to meet liabilities as they fall due.

31/12/2004

PRU 2.3.27

When assessing liquidity risk, the firm should consider the extent of mismatch between assets and liabilities and the amount of assets held in highly liquid, marketable forms should unexpected cashflows lead to a liquidity problem. The price concession of liquidating assets is a prime concern when assessing such liquidity risk and should be built into any assessment of capital adequacy.

31/12/2004

PRU 2.3.28

Some further areas to consider in developing the liquidity risk scenario might include:

(1) any mismatching between expected asset and liability cash flows;
(2) the inability to sell assets quickly;
(3) the extent to which the firm's assets have been pledged;
(4) the cash-flow positions generally of the firm and its ability to withstand sharp, unexpected outflows of funds via claims, or an unexpected drop in the inflow of premiums; and
(5) the possible need to reduce large asset positions at different levels of market liquidity, and the related potential costs and timing constraints.

31/12/2004

Factors to consider when assessing operational risk

PRU 2.3.29

Operational risk refers to the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.

31/12/2004

PRU 2.3.30

A firm may wish to refer to SYSC 3A and PRU 6.1 when carrying out its operational risk assessment.

31/12/2004

PRU 2.3.31

Examples of some issues that a firm might want to consider include:

(1) the likelihood of fraudulent activity occurring that may impact upon the financial or operational aspects of the firm;
(2) the obligation a firm may have to fund a pension scheme for its employees;
(3) the technological risks that the firm may be exposed to regarding its operations. For example, risks relating to both the hardware systems and the software utilised to run those systems;
(4) the reputational risks to which the firm is exposed. For example, the impact on the firm if the firm's brand is damaged resulting in a loss of policyholders from the underwriting portfolio;
(5) the marketing and distribution risks that the firm may be exposed to. For example, the dependency on intermediary business or a firm's own sales force;
(6) the impact of legal risks. For example a non-insurance related legal action being pursued against the firm;
(7) the management of employees - for instance staff strikes, where dissatisfied staff may withdraw goodwill and may indulge in fraud or acts giving rise to reputational loss;
(8) the resourcing of key functions such as the risk management function by staff in appropriate numbers and with an appropriate mix of skills such as underwriting, claims handling, accounting, actuarial and legal expertise.

31/12/2004

PRU 2.3.32

A firm may consider that investigation of operational weaknesses and corrective action is a better response than holding capital and may consider that a certain degree of operational risk is within its pre-defined risk tolerance. However, until the firm corrects any identified deficiencies a firm should consider capital as a (interim) response to the risk.

31/12/2004

Factors to consider when assessing insurance risk

PRU 2.3.33

As a result of the differences between the nature of general and long-term insurance business, some aspects of the risk assessment vary depending on the type of business written. In assessing potential insurance risk events that may affect the firm's solvency, general and long-term insurance business firms should:

(1) analyse the potential for catastrophic losses, including both risk and event losses, the cost of reinstatement premiums and any possible reinsurance exhaustion; and
(2) determine the likelihood of any other feature of insurance risk that may lead to a variation in projected outcomes.
(3) Firms carrying on general insurance business should in addition:

(a) analyse the potential for claims reserves to deteriorate beyond the current reserving level; and
(b) determine the effect of loss ratios being higher than planned by analysing historic loss ratio experience and volatility.

(4) Firms carrying on long-term insurance business should in addition:

(a) analyse the potential for mathematical reserves subsequently to prove inadequate compared with the current reserving level; and
(b) determine the effect of claims experience being more costly than planned by analysing historic claims experience, volatility and trends in experience.

31/12/2004

PRU 2.3.34

Some further areas to consider in developing the insurance risk scenario might include:

(1) For underwriting risks, general insurance business and long-term insurance business firms:

(a) the adequacy of the firm's pricing. For example, the firm should be able to satisfy itself that it can charge adequate rates, taking into account the business and the risk profile of different products, the business environment (e.g. premium cycle-non-life) and its own internal profit targets;
(b) the uncertainty of claims experience;
(c) the dependence on intermediaries for a disproportionate share of the insurer's premium income; the effects of a high level of uncertainty in pricing in new or emerging underwriting markets due to a lack of information needed to enable the insurer to make a proper assessment of the price of the risk; the geographical mix of the portfolio or whether any geographical or jurisdictional concentrations exist;
(d) the appropriateness of policy wordings;
(e) the risk of mis-selling, for example, the number of complaints or disputed claims; and
(f) the tolerance for expense reserve variations or variations in expenses (including indirect costs).

(2) For firms carrying on general insurance business, in addition:

(a) the length of tail of the claims development and latent claims; and
(b) the effects of rapid growth or decline in the volume of the underwriting portfolio.

(3) For firms carrying on long-term insurance business, in addition:

(a) the uncertainty of future investment returns;
(b) the effects of rapid growth or decline in the volume and nature of new business written; and
(c) the ability of firms to adjust premium rates or charges for some products.

(4) For reserving and claims risks, both general insurance business and long term insurance business firms:

(a) the frequency and size of large claims;
(b) possible outcomes relating to any disputed claims, particularly where the outcome is subject to legal proceedings;
(c) the ability of the firm to withstand catastrophic events, increases in unexpected exposures, latent claims or aggregation of claims;
(d) the possible exhaustion of reinsurance arrangements, both on a per risk and per event basis;
(e) social changes regarding an increase in the propensity to claim and to sue; and
(f) other social, economic and technological changes.

(5) For firms carrying on general insurance business:

(a) the adequacy and uncertainty of the technical claims provisions, such as outstanding claims, IBNR and claims handling expense reserves;
(b) the adequacy of other underwriting provisions, such as the provisions for unearned premium and unexpired risk reserves;
(c) the appropriateness of catastrophe models and underlying assumptions used, such as possible maximum loss (PML) factors used;
(d) unanticipated legal judgements and legal change with retrospective effect specifically with regard to the claims reserves; and
(e) the effects of inflation.

(6) For firms carrying on long-term insurance business:

(a) the adequacy and sensitivity of the mathematical reserves to variations in future experience, including:

(i) the risk that investment returns differ from those assumed in the reserving assumptions;
(ii) the risk of variations in mortality, morbidity and persistency experience and in the exercise of options under contracts;
(iii) the rates of taxation applied, in particular where there is uncertainty over the tax treatment; and

(b) unanticipated legal judgements and legal change with retrospective effect specifically with regard to the impact on mathematical reserves.

31/12/2004

Other assessments of the adequacy of capital resources

PRU 2.3.35

Firms must assess the adequacy of their financial resources and this will entail an assessment of both capital resources and liquidity resources. The stress tests and scenario analyses which a firm must carry out will assist with both assessments. However, firms may also find it helpful to approach their assessment of capital in another way.

31/12/2004

PRU 2.3.36

Firms may also wish to carry out an additional assessment to inform their view as to whether their capital resources are adequate. The additional assessment is to consider the extent to which the capital resources requirement (CRR) produces adequate capital for a firm's particular circumstances. In considering this, firms that are required to calculate an Enhanced Capital Requirement (ECR) may wish to note that the ECR as calculated is based upon the assumptions that a firm's business is well diversified, well managed with assets matching its liabilities and good controls, and stable with no large, unusual, or high risk transactions. Firms may find it helpful to assess the extent to which their actual business differs from these assumptions and therefore what adjustments it might be reasonable to make to the CRR or ECR to arrive at an adequate level of capital resources.

31/12/2004

PRU 2.3.37

Firms may find it helpful for their own assessment process if they also consider divergences from the assumptions described in PRU 2.3.36 G under the headings set out below. These are the areas which the FSA considers when forming its view of the adequacy of a firm's capital resources.
Business risk factors:

(1) market risk;
(2) securitisation risk;
(3) residual risk;
(4) concentration risk;
(5) high impact, low probability events; and
(6) cyclicality and capital planning.

Control risk factors:

(1) systems and controls.

31/12/2004

PRU 2.3.38

Market risk: a firm should assess its exposure to those elements of market risk that are not captured by the CRR. In doing so, firms may wish to use stress tests to determine the impact on their balance sheets of an appropriate move in market conditions. The results of this test should then be used by the firm to determine its market risk.

31/12/2004

PRU 2.3.39

Securitisation risk: a firm should assess its exposure to risks transferred through the securitisation of assets should those transfers fail for whatever reason. For instance, firms may contemplate two broad types of securitisation: 'embedded value securitisation' - the transfer of the value emerging from an existing block of business to bondholders; and 'risk transfer securitisation' - the purchase of protection against catastrophic risks to the insurer through the issuance of bonds whose repayment is contingent upon the non-occurrence of such risks. In either case, firms should consider the effect on their financial position of a failure of such complex arrangements to operate as anticipated or the values and risks transferred not emerging as expected.

31/12/2004

PRU 2.3.40

Residual risk: a firm should assess its exposure to the residual risks that may result from the partial performance or failure of risk mitigation techniques for reasons that are unconnected with their intrinsic value. This could result from (for example): ineffective documentation, a delay in payment or the inability to realise payment from a guarantor in a timely manner. Given that residual risks can always be present, firms should assess the appropriateness of their capital resources requirement against their assumptions for the risk mitigation measures that they may have in place.

31/12/2004

PRU 2.3.41

Concentration risk: a firm should assess and monitor its exposure to: sector, geographic, liability and asset concentrations, as well as granularity. The FSA considers that concentrations in these areas increase the firm's credit risk and where the firm identifies concentrations then they should consider the adequacy of the capital resources requirement. For instance, firms should monitor concentrations of exposure to particular reinsurers and ensure that they are aware of the implications of several of their reinsurers failing at the same time.

31/12/2004

PRU 2.3.42

High impact, low probability events: firms should consider stress tests and scenario analyses which are realistic - that is not too remote a possibility. However, should a firm decide to enter into a high impact, low probability transaction, the firm should satisfy itself that it has sufficient financial resources to meet its resulting financial obligation in the event the single risk materialises. For instance, a firm should not accept individual risks in circumstances where, if that single risk materialised, the claim arising would exceed the financial resources available to the firm.

31/12/2004

PRU 2.3.43

A firm should also consider the value of the financial obligation arising where the risks from a combination of high impact, low probability transactions that the firm has entered into materialise at the same time. A firm should ensure that in no circumstances would a combination of any consequent claims materially exceed the financial resources available to it.

31/12/2004

PRU 2.3.44

Cyclical and capital planning: a firm's capital resources requirement may vary as business cycles and economic conditions fluctuate over time. Firms should be aware that a deterioration in business or economic conditions could require them to raise capital or alternatively to contract their businesses at a time when market conditions are most unfavourable to raising capital. Such an effect is known as procyclicality.

31/12/2004

PRU 2.3.45

To reduce the impact of cyclical effects, firms should look to build-up capital levels through the course of an upturn in business and economic cycles to ensure that they have sufficient capital available to protect themselves against adverse conditions.

31/12/2004

PRU 2.3.46

To assess its expected capital requirements over the economic and business cycles, a firm may wish to project forward its financial position taking account of its business strategy and expected growth under a range of environmental assumptions. Projections over a three to five year period would be appropriate in most circumstances. Firms may then calculate their projected capital resources requirement and assess whether that requirement could be met from expected financial resources.

31/12/2004

PRU 2.3.47

Systems and controls: a firm may decide to hold additional capital resources to mitigate weaknesses in its overall control environment. Weaknesses might be indicated by the following:

(1) a failure by the firm to complete an assessment of its systems and controls in line with SYSC 3.1 (Systems and Controls) and PRU 1.4;
(2) a failure by the firm's senior management to approve its financial results; and
(3) a failure by the firm to consider an analysis of relevant internal and external information on its business and control environment.

31/12/2004

PRU 2.3.48

In considering any systems and control weaknesses and their effect on the adequacy of the capital resources requirement, a firm may wish to be able to demonstrate to the FSA that all the issues identified in SYSC 3.2 (Areas covered by systems and controls) have been considered; and that appropriate plans and procedures exist to deal adequately with adverse scenarios.

31/12/2004

Capital models

PRU 2.3.49

A firm may approach its assessment of adequate capital resources by developing a model for some or all of its business risks. Where such a model captures some of the risks identified in accordance with PRU 1.2.31 R then this will usually satisfy the requirement to perform stress tests in respect of those risks. However, the assumptions required to aggregate risks modelled and the confidence levels adopted should be considered by the firm's senior management. A firm should also consider whether any risks are not captured by the model and also the extent to which systems and control risks are not incorporated in the model.

31/12/2004

PRU 2.3.50

A firm should not expect the FSA to accept as adequate any particular model that it develops or that the results from the model are automatically reflected in any individual guidance given to the firm for the purpose of determining adequate capital resources. However, the FSA will take into account the results of any sound and prudent model when giving individual guidance or considering applications for a waiver under section 148 of the Act of the capital resources requirement in PRU 2.1. This section sets out the types of issues the FSA would consider before giving individual guidance or granting a waiver based on the results of a model.

31/12/2004

PRU 2.3.51

There is no prescribed modelling approach for how a firm develops its internal model. However, firms should be able to demonstrate:

(1) the extent of use of the internal capital model within the firm's capital management policy;
(2) that sound and appropriate risk-management techniques are employed and are embedded in the daily operations and financial resources requirements of the firm;
(3) that all material risks to which the firm is exposed have been adequately addressed by quantitative and qualitative means as appropriate;
(4) the confidence levels set and whether these are linked to the firm's corporate strategy;
(5) the time horizons set for the different types of business that the firm undertakes;
(6) the extent of historic data used and back testing carried out; and
(7) whether sufficient accuracy and validation in the internal capital model has been undertaken.

31/12/2004

Quantitative factors

PRU 2.3.52

The firm's model should be based on an appropriate probability of insolvency over an appropriate time period. A firm should be able to demonstrate the selected probability of insolvency and time horizon it has derived and explain why these are appropriate for its business.

31/12/2004

PRU 2.3.53

Good models will have as inputs (in addition to the specific examples given under the stress and scenario guidance):
For both firms carrying on general insurance business and long-term insurance business:

(1) assumed future investment returns. In particular, assumptions for future interest rates (to the extent that they impact on interest income on funds on deposit, price of and yield on fixed stock that may be purchased in future and interest income on variable interest rate assets), equity prices, dividend income, property prices, property rental income and inflation. The assumptions should take account of likely volatility and historic volatility in interest rates and asset prices;
(2) five-year predictions as to premium rates in each homogeneous category of business taking account of the effect of underwriting cycles;
(3) predictions of exposures written in each homogeneous category of business in the next five years;
(4) predictions of premium volume and expected growth under a five year business plan;
(5) expenses and commission;
(6) catastrophic events, aggregations of claims and claims affecting more than one class of business;
(7) inflation in terms of how it might affect future claims, non-settled claims that have occurred to date, future expenses, future reinsurance costs and future investment returns;
(8) reinsurance programmes in place, allowing for changing term conditions, reinstatements and loss experience features;
(9) estimates of non-recovery of reinsurance and other debtors taking account of the financial strength of each reinsurance or other counterparty; and
(10) foreign exchange movements.

For firms carrying on general insurance business in particular:

(11) frequency and severity of claims (including costs associated with claims such as professional fees) for each homogeneous category of business, allowing for any impact of future social, legal and inflationary effects (especially concerning price, earnings, medical and claims) on future claims costs;
(12) settlement patterns of claims and reinsurance recoveries for each homogeneous category of business (including occurred and future claims);
(13) unintended coverage of risks; and
(14) correlation between these risks.
For firms carrying on long-term insurance business in particular:
(15) projected claims experience for each homogeneous category of business allowing for trends in mortality/ morbidity experience;
(16) assumptions for future policyholder actions such as lapsing or surrendering a policy, ceasing to pay premiums or choosing to exercise an option under the contract; and
(17) for business where management has discretion over the level of benefits or charges, assumptions about management reactions to changes in economic conditions and consequent changes to the benefits or charges.

31/12/2004

PRU 2.3.54

The FSA places credence in approaches to financial models to aid the assessment of capital adequacy which involve the production of a Dynamic Financial Analysis ("DFA") model. These models transform each element in the financial projection into a statistical distribution with a range of possible outcomes, and are therefore stochastic. They would generally incorporate a suitable economic model integrated into the DFA model and linked into the generation of insurance related assumptions. The model would, as far as possible, cover all risks and all areas of business. The future time period over which projections are made should be determined with reference to the type of insurance business written, the asset profile and the insurance cycle. It may be appropriate to consider several different time periods.

31/12/2004

PRU 2.3.55

Due regard should also be given to the historical experience of both the firm and the wider relevant industry and market when assigning values to the above inputs.

31/12/2004

PRU 2.3.56

The values assigned to each of the above inputs should be derived either stochastically, by assuming the value of an item can follow an appropriate probability distribution and by selecting appropriate values at the tail of the distribution, or deterministically, using appropriate prudent assumptions. For long-term insurance business which includes options or guarantees that change in value significantly in certain economic or demographic circumstances, a stochastic approach would normally be appropriate.

31/12/2004

PRU 2 Annex 1

Admissible assets in insurance

31/12/2004

(1)

Investments that are, or amounts owed arising from the disposal of:

(a)debt securities, bonds and other money and capital market instruments; (b) loans;(c)shares and other variable yield participations;(d) units in UCITS schemes, non-UCITS retail schemes, recognised schemes and any other collective investment scheme that invests only in admissible assets (including any derivatives or quasi-derivatives held by the scheme);(e) land, buildings and immovable property rights;(f) an approved derivative or quasi-derivative transaction that satisfies the conditions in PRU 4.3.5 R or an approved stock lending transaction that satisfies the conditions in PRU 4.3.36 R.

(2)

Debts and claims

(a)debts owed by reinsurers, including reinsurers' shares of technical provisions;(b)deposits with and debts owed by ceding undertakings;(c) debts owed by policyholders and intermediaries arising out of direct and reinsurance operations (except where overdue for more than 3 months and other than commission prepaid to agents or intermediaries);(d) for general insurance business only, claims arising out of salvage and subrogation;(e) for long-term insurance business only, advances secured on, and not exceeding the surrender value of, long-term insurance contracts issued by the insurer;(f) tax recoveries;(g) claims against compensation funds.

(3)

Other assets

(a) tangible fixed assets, other than land and buildings;(b) cash at bank and in hand, deposits with credit institutions and any other bodies authorised to receive deposits;(c) for general insurance business only, deferred acquisition costs;(d) accrued interest and rent, other accrued income and prepayments;(e) for long-term insurance business only, reversionary interests.

31/12/2004

PRU 2 Annex 2

Guidance on applications for waivers relating to implicit items Implicit items under the Act

31/12/2004

PRU 2.2.14 R does not permit implicit items to be included in the calculation of a firm's capital resources, except subject to a waiver under section 148 of the Act. Article 27(4) of the Consolidated Life Directive states that implicit items can be included in the calculation of a firm's capital resources, within limits, provided that the supervisory authority agrees. Certain implicit items, however, are not eligible for inclusion beyond 31 December 2009 (see paragraph 5). The FSA may be prepared to grant a waiver from PRU 2.2.14 R to allow implicit items, in line with the purpose of the Consolidated Life Directive, and provided the conditions as set out in article 27(4) of the Consolidated Life Directive are met. Such a waiver would allow an implicit item to count towards the firm's capital resources available to count against its capital resources requirement (CRR) set out for realistic basis life firms in PRU 2.1.15 R and for regulatory basis only life firms in PRU 2.1.20 R. Where a firm applies for an implicit item waiver the firm may also apply for a waiver from PRU 2.2.16 R, which requires at least 50% of a firm's MCR to be covered by core tier one capital and perpetual non-cumulative preference shares. Under PRU 2.2.17 R a firm must meet the guarantee fund from the sum of the items listed at stages A, B, G and H less the sum of the items listed at stage E of PRU 2.2.14 R. PRU 2.2.17 R addresses the requirement in article 29(1) of the Consolidated Life Directive that implicit items should be excluded from capital eligible to cover the guarantee fund. Where an implicit items waiver is granted, an implicit item may potentially count as either tier one or tier two capital, but not core tier one capital. PRU 2.2.20 R requires that at least 50% of a firm's tier one capital resources must be accounted for by core tier one capital.

Under section 148 of the Act, the FSA may, on the application of a firm, grant a waiver from PRU. There are general requirements that must be met before any waiver can be granted. As explained in SUP 8, the FSA may not give a waiver unless the FSA is satisfied that:

(1)

compliance by the firm with the rules will be unduly burdensome, or would not achieve the purpose for which the rules were made; and

(2)

the waiver would not result in undue risk to persons whose interests the rules are intended to protect.

The FSA will assess compliance with the requirements in the light of all the relevant circumstances. This will include consideration of the costs incurred by compliance with a particular rule or whether a rule is framed in a way that would make compliance difficult in view of the firm's circumstances. For example, the firm may demonstrate that if an implicit item were not allowed, the firm would either have to suffer increased (and unwarranted) costs in injecting further capital resources or operate with a lower equity backing ratio (see case studies in paragraph 43). Even if a firm can demonstrate a case for an implicit item waiver, it should not assume that the FSA will grant the waiver requested, or that any waiver will be granted for the full amount of the implicit item which could be granted, as set out in this annex. The FSA will consider each application on its own merits, and taking into account all relevant circumstances, including the financial situation and business prospects of the firm.

Implicit items are economic reserves which are contained within the long-term insurance business provisions. Article 27(4) of the Consolidated Life Directive identifies three types of implicit item, in respect of: future profits, zillmerisation and hidden reserves. This annex is intended to amplify the guidance in SUP 8 relating to the granting of waivers for implicit items and to provide guidance on other aspects. Whilst this guidance applies to applications for waivers for implicit items generally, for a realistic basis life firm, to the extent that an implicit item is allocated to a with-profits fund, this guidance relates to implicit items for the purposes of determining the regulatory value of assets (see PRU 7.4.24 R).

The Consolidated Life Directive (reflecting the changes introduced by the Solvency 1 Directive) requires member states to end a firm's ability to take into account future profits implicit items by (at the latest) 31 December 2009. Until then, the maximum amount of the implicit item relating to future profits permitted under the Consolidated Life Directive is limited to 50% of the product of the estimated annual profits and the average period to run (not exceeding six years) on the policies in the portfolio. The Consolidated Life Directive further limits the maximum amount of these economic reserves that can be counted to 25% of the lesser of the available solvency margin and the required solvency margin. The changes introduced by the Solvency 1 Directive take effect for financial years beginning on or after 1 January 2004. However, the Consolidated Life Directive allows for a transitional period of five years, which runs from 20 March 2002 (the publication date of the Solvency 1 Directive), for firms to become fully compliant with these new requirements. Firms will need to consider the potential impact of these changes when engaging in future capital planning. When applying for an implicit item waiver a firm should provide the FSA with a plan showing how the firm intends to maintain its capital adequacy over the period to 31 December 2009. Firms should also be aware that the FSA will typically only grant waivers for a maximum of 12 months.

Future Profits

The future profits implicit item allows firms to take credit for margins in the mathematical reserves to the extent that these are expected to emerge from in force business. The future profit from in force business should be assessed, in the first instance, on prudent assumptions, to demonstrate that there is an 'economic reserve'. Having demonstrated that it exists, the amount should be limited to an amount calculated using a formula that takes into account the actual profit which has emerged over the last five years (see paragraph 28).

Zillmerisation

Zillmerisation is an allowance for acquisition costs that are expected, under prudent assumptions, to be recoverable from future premiums. Firms can make a direct adjustment to their reserves for zillmerisation, subject to the rules on mathematical reserves. However, where no such adjustment has been made, the FSA will consider an application for a waiver to take into account an implicit item.

Hidden reserves

Hidden reserves are reserves resulting from the underestimation of assets (other than mathematical reserves).

Process for applying for a waiver, including limits applicable when a waiver is granted

This annex sets out the procedures to be followed and the form of calculations and data which should be submitted by firms to the FSA. This guidance should also be read in conjunction with the general requirements relating to the waiver process described in SUP 8. The FSA expects that applications for waivers in respect of future profits and zillmerising will not normally be considered to pass the "not result in undue risk to persons whose interests the rules are intended to protect" test unless the relevant criteria set out in this guidance have been satisfied and an application for such a waiver may require further criteria to be satisfied for this test to be passed. As set out below, waivers in respect of either zillmerising or hidden reserves will not normally be given except in very exceptional circumstances.

Timing

A long-term insurer may apply to the FSA for a waiver in respect of implicit items. A waiver will not apply retrospectively (see SUP 8.3.6 G). Consequently, applications intended for a particular accounting reference date will normally need to be made well before that reference date. Applications by firms must be made to the FSA in writing and include the relevant details specified under SUP 8.3.3 D. Given the uncertainty in predicting the future, waivers will normally be granted for a maximum of 12 months at a time and any further applications will need to be made accordingly.

The information that will be required to enable an application to be considered as set out below, should normally include a demonstration of how the capital resources requirement is to be met, with and without the waiver. Clearly, up-to-date information may not be available before the financial year-end. In some cases information from the previous year-end's return may be used, as long as any known significant changes in the structure of the firm, or the assumptions used, have been taken into account.

If the application for a waiver is granted, when a firm submits its next return the amount of the implicit item shown should not exceed that supported by the firm's calculations as at the valuation date. In the event that the amount of the future profits item calculated by the firm based on these updated assumptions is less than the amount calculated at the time of the firm's waiver application, the lower figure should be used in the return.

An implicit item in respect of zillmerising or hidden reserves is related to the basis on which liabilities or assets have been valued. In the case of hidden reserves, as explained below, the granting of a waiver will be dependent on the overall capital resources of the firm. Waivers in respect of these implicit items will, therefore, only be made in relation to the position shown in a particular set of returns and it will be essential for firms to submit applications to the FSA well in advance of the latest date for the submission of the relevant return.

Waivers may be withdrawn by the FSA at any time (e.g. where the FSA considers the amount in respect of which a waiver has been given can no longer be justified). This may be as a result of changes in the firm's position or as a result of queries arising on scrutiny of the returns.

Information to be submitted

An application for a waiver (which includes an application for an extension to or other variation of a waiver) should be prepared using the standard application form for a waiver (see SUP 8 Annex 2D). In addition, the application should be accompanied by full supporting information to enable the FSA to arrive at a decision on the merits of the case. In particular, the application should state clearly the nature and the amounts of the implicit items that a firm wishes to count against its capital resources requirement and the treatment it proposes to adopt in counting the implicit items towards the firm's capital resources. Furthermore, the application should demonstrate that in allowing for implicit items there has been no double counting of future margins and that the basis for valuing such margins is prudent.

The FSA recognises that the assessment of the insurance technical provisions reflects the contractual obligations of the firm. Implicit items are therefore margins over and above an economic assessment in these technical provisions only. Non-contractual "constructive" obligations arising from a firm's regulatory duty to treat customers fairly e.g. regarding future terminal bonuses, are not fully captured by the technical provisions. A firm must instead be satisfied that it has sufficient capital resources at all times to meet its obligations under Principle 6. The granting of a waiver for an implicit item does not in any way detract from this requirement and a firm will need to be satisfied that this condition is still met.

As a minimum, applications for a future profits implicit item should be supported by the information contained in Forms 13, 14, 18, 19, 40, 41, 42, 48, 49, the answers to questions 1 to 12 of the abstract of the valuation report, Appendix 9.4 of IPRU(INS), the abstract of the valuation report for the realistic valuation, Appendix 9.4A of IPRU(INS) and Forms 51, 52, 53, 54 and 58. For a zillmerisation implicit item, only those items noted above forming part of the abstract valuation report will normally be needed. Applications for a waiver in respect of a hidden reserves implicit item will normally be considered only if accompanied by the information which is contained in the annual regulatory returns. In particular, the balance sheet forms, long-term insurance business revenue accounts, and abstract of the valuation report as set out in Appendices 9.1, 9.3 and 9.4 of IPRU(INS) should be provided. This is not to say that a full regulatory return must be provided in the specified format, simply that the information contained in these forms should be provided. Where appropriate, the information may be summarised.

The following supporting information relating to the calculation of the amounts claimed should be supplied for each type of implicit item in respect of which a waiver is sought:
Future profits: in addition to information related to the prospective calculation and retrospective calculation described below, the profits reported in each of the last five financial years up to the date of the most recent available valuation under rule 9.4 of IPRU(INS) which has been submitted to the FSA prior to, or together with, the application, and the amounts and nature of any exceptional items left out of account; the method used for calculating the average period to run and the results for each of the main categories of business, both before and after allowing for premature termination (where the calculation has been made in two stages); and the basis on which this allowance has been made.
Zillmerising: the categories of contracts for which an item has been calculated and the percentages of the relevant capital sum in respect of which an adjustment has been made.
Hidden reserves: particulars, with supporting evidence, of the undervaluation of assets for which recognition is sought.

Continuous monitoring by firms

Firms should take into account any material changes in financial conditions or other relevant circumstances that may have an impact on the level of future profits that can prudently be taken into account. Firms should also re-evaluate whether an application to vary an implicit item waiver should be made whenever circumstances have changed. In the event that circumstances have changed such that an amendment is appropriate, the firm must contact the FSA as quickly as possible in accordance with Principle 11. (See SUP 8.5.1 R). In this context, the FSA would expect notice of any matter that materially impacts on the firm's financial condition, or any waivers granted.

Future profits - factors to take into account when submitting calculations to support waiver applications

Where an application is made in respect of a firm which has separate with-profits funds and non-profit funds, the firm should ensure that the capital resources requirement in respect of the non-profit fund is not covered by future profits attributable to policyholders arising in the with-profits fund. Furthermore, for a realistic basis life firm the amount of the implicit item allocated to each with-profits fund should be calculated separately, as the amount allocated to each with-profits fund will be taken into consideration in the calculation of the with-profits insurance capital component (see PRU 7.4.24 R).

Firms need to assess prospective future profit (i.e. how much can reasonably be expected to arise) and compare this to maximum limits (in article 27(4) of the Consolidated Life Directive), which relate to past profits.

Future profits - prospective calculation

The application for a waiver should be supported by details of a prospective calculation of future profits arising from in-force business. The information supplied to the FSA should include a description of the method used in the calculation and of the assumptions made, together with the results arising. From 31 December 2009 at the latest, future profits implicit items will no longer be permitted under the Consolidated Life Directive. Where a firm first applies for an implicit items waiver after PRU 2.2 comes into effect, under the prospective calculation a firm should only take into consideration future profits that are expected to emerge in the period up to 31 December 2009. Implicit item waivers granted before PRU 2.2 comes into effect will continue to operate under the terms of those waivers, but an application to vary the terms of such a waiver, for example to extend the effective period, is an application for a new waiver for which a firm should usually only take into consideration future profits that are expected to emerge in the period up to 31 December 2009.

Assumptions

The assumptions made should be prudent, rather than best estimate, assumptions of future experience (that is, the prudent assumptions should allow for the fair market price for assuming that risk including associated expenses). In particular, it would not normally be considered appropriate for the projected return on any asset to be taken to be higher than the risk-free yield (that is, assessed by reference to the yield arrived at using a model of future risk free yields properly calibrated from the forward gilts market). It may also be appropriate to bring future withdrawals into account on a suitably prudent basis. For with-profits business, the assumptions for future investment returns should not capitalise future bonus loadings except where the with-profits policyholders share in risks other than the investment performance of the fund. Furthermore, the rate at which future profits are discounted should include an appropriate margin over a risk free rate of return. Calculations should also be carried out to demonstrate that the prospective calculation of the future profits arising from the in-force business supporting the application for the implicit item would be sufficient to support the amount of the implicit item under each scenario described for use in determining the resilience capital requirement - where the waiver relates to an implicit item allocated to more than one fund, this should be demonstrated separately for that element of the implicit item allocated to each fund. For an implicit item allocated to a with-profits fund, proper allowance should be made for any shareholder transfers to ensure that the implicit item is not supported by future profits which will be required to support those transfers. To the extent, if any, that future profits are dependent on the levying of explicit expense related charges (for example as in the case of unit-linked business) the documentation submitted should include a demonstration of the prudence of the assumptions made as to the level at which future charges will be levied and expenses incurred.

Other limitations on the extent to which waivers for implicit items will be granted to a realistic basis life firm

Where a waiver in respect of an implicit item is granted to a realistic basis life firm additional limits may apply by reference to a comparison of realistic excess capital and regulatory excess capital including allowance for the effect of the waiver. Where the waiver relates to an implicit item allocated partly or entirely to a with-profits fund, the waiver will contain a limitation to the effect that the regulatory excess capital for that with-profits fund, allowing for the effect of the waiver, may not exceed that fund's realistic excess capital. This limitation will apply on an ongoing basis so that, for example, in the case of an implicit item allocated to a with-profits fund, the amount of the implicit item would be limited to zero whenever the regulatory excess capital exceeded the realistic excess capital of that fund.

Other charges to future profits

To avoid double counting, no account should be taken of any future surplus arising from assets corresponding to explicit items which have been counted towards the capital resources requirement such as shareholders funds, surplus carried forward or investment reserves. Deductions should be made in the calculation of future surpluses for the impact of any other arrangements which give rise to a charge over future surplus emerging (e.g. financial reinsurance arrangements, subordinated loan capital or contingent loan agreements). Deductions should also be made to the extent that any credit has been taken for the purposes of PRU 7.4.45 R (2)(c) for the present value of future profits relating to non-profit business written in a non-profit fund. The information supplied to the FSA should identify the amount and reason for any adjustments made to the calculation of the prospective amount of future profits.

The firm should confirm to the FSA that the calculations have been properly carried out and that there are no other factors that should be taken into account.

Future profits - retrospective calculation

Overriding limit

The maximum amount of the implicit item relating to future profits permitted under the Consolidated Life Directive is 50% of the product of the estimated annual profit and the average period to run (not exceeding six years (ten years during the transitional period referred to in paragraph 5)) on the policies in the portfolio. Article 27(4) of the Consolidated Life Directive also imposes a further limit on the amount of the implicit item equal to 25% of the lower of:

(1)

the firm's capital resources; and

(2)

the higher of its base capital resources requirement for long-term insurance business and its long-term insurance capital requirement.

Once the transitional period set out in article 71(1) of the Consolidated Life Directive has expired in 2007 (see paragraph 5), the FSA will not allow a waiver for more than the amount permitted by article 27(4) of the Directive.

Definition of profits

The estimated annual profit should be taken as the average annual surplus arising in the long-term insurance fund over the last five financial years up to the date of the most recent available valuation which has been submitted to the FSA prior to, or together with, the application. For this purpose, deficiencies arising should be treated as negative surpluses. Where a firm's financial year has altered, the surplus arising in a period falling partly outside the relevant five year period should be assumed to accrue uniformly over the period in question for the purpose of estimating the profits arising within the five year period. When there has been a transfer of a block of business into the firm (or out of the firm) during the period, the impact of the transfer will need to be taken into account to reflect the remaining portfolio.

Where a firm has been carrying on long-term insurance business for less than 5 years, the total profits made during the past five years should be taken to be the aggregate of any surpluses that have arisen during the period in which long-term insurance business has been carried on less any deficiencies that may have arisen during that period. The resulting total should still be divided by five to obtain the estimated annual profit.

Exceptional items

Substantial items of an exceptional nature should be excluded from the calculation of the estimated annual profit. Such items include profits arising from an exceptional change in the value at which assets are brought into account, where this is not reflected in a similar change in the amount of the liabilities, and profits arising from a change in the overall valuation approach between one year and another. An exceptional loss (i.e. a reduction of an exceptional nature in the surplus arising) may be excluded from the calculation only to the extent that it can be set against a profit or profits up to the amount of the loss and arising from a similar cause. It is not intended, however, that any adjustment should be made for the effect on surplus of a net strengthening of reserves for costs associated with an expansion of the business or for special capital expenditure, such as the purchase of computer systems.

Double counting

The inclusion of investment income arising from the assets representing the explicit components of capital resources (as part of the estimated annual profit for the purpose of determining the future profits implicit item) would result in double-counting. If those assets were required to meet the effects of adverse developments, this would automatically result in the cessation of the contribution to profits from the associated investment income. It would clearly not be appropriate for the FSA to grant a waiver which would enable a firm to meet the capital resources requirement on the basis of counting both the capital values of the assets and the value of the income flow which they can be expected to generate.

The definition of the estimated annual profit as the surplus arising in the long-term insurance fund ensures that any contribution to surplus arising from transfers from the profit and loss account, including investment income on shareholders' assets, is not included in the estimated annual profit. Thus double-counting should not arise in respect of shareholders' assets. Double-counting may arise, however, in respect of the investment income from the assets representing the explicit components of capital resources carried within the long-term insurance fund (e.g. surplus carried forward or investment reserves), but the amount of such investment income is not separately identified in the return.

Where there is reason to suspect that the elimination of any such double-counting would reduce a firm's capital resources to close to or below the required level, or would otherwise be significant, the FSA will request this information with a view to taking account of this factor in determining the amount of the implicit item. Additional information concerning investment income should be furnished with an application for a waiver, if a firm believes that any double-counting would fall into one of the categories mentioned above.

Average period to run

The average number of years remaining to run on policies should be calculated on the basis of the weighted average of the periods for individual contracts of insurance, using as weights the actuarial present value of the benefits payable under the contracts. A separate weighted average should be calculated for each of the various categories of contract and the results combined to obtain the weighted average for the portfolio as a whole. Approximate methods of calculation, which the firm considers will give results similar to the full calculation, will be accepted. In particular, the FSA will normally accept the calculation of an average period to run for a specific category of contract on the basis of the average valuation factor for future benefits derived from data contained in the abstract of the valuation report in the regulatory returns. A firm will be asked to demonstrate the validity of the method adopted only where an abnormal distribution of the business in force gives grounds for doubt about its accuracy.

Calculations will normally be requested only for the main categories of insurance business, accounting for not less than 90% of the mathematical reserves, except where there are grounds for expecting that the exclusion of certain categories of policies under this provision might have a significant effect on the resulting average period to run. Detailed calculations will not be required where a waiver is sought in respect of a low multiple of the annual profits, well within the average period to run for the firm.

Where, for a particular category of business, a method of valuation is used which does not involve the calculation of the value of future benefits and which is significant for the firm in question, the calculation of the average period to run should be based on estimates of the value of future benefits.

Premature termination of contracts

Allowance should be made for the premature termination of contracts of insurance, based on the actual experience of the firm over the last five years, or other appropriate period, and taking into account specific features of contracts such as options which can be expected to lead to premature termination (e.g. guaranteed surrender values on income bonds written as long-term insurance contracts and option dates on flexible whole-life contracts). The adjustment should be made separately for each of the main categories of business. The use of industry-wide rates of termination will be acceptable where a firm is satisfied that this will result in sufficient allowance being made having regard to the firm's own experience. Methods of calculation that involve a degree of approximation will be permitted.

For certain types of contract, where the period left to run is most naturally defined as the term to a fixed maturity or expiry date, the allowance for premature termination should also take into account terminations resulting from death.

Overall limit

The overall average period left to run calculated as described above should be limited to a maximum of six years under article 27(4) of the Consolidated Life Directive (or a maximum of ten years during the transitional period referred to in paragraph 5) before applying it to the estimated annual profit in order to determine the maximum value of the future profits implicit item.

Definition of period to run

The definition of the period to run and the basis of the allowance for early termination should clearly be considered together. For certain types of contracts (e.g. pension contracts with a range of retirement ages or other options), there is inherent uncertainty about the likely term to run. In such circumstances any estimate for determining the amount of the future profits implicit item for which a waiver is sought should be based on prudent assumptions tending, if anything, to underestimate the average period to run.

Zillmerising

The FSA does not normally expect to grant waivers permitting implicit items due to zillmerisation except in very exceptional circumstances. Zillmerisation is an allowance for acquisition costs that are expected, under prudent assumptions, to be recoverable from future premiums. Firms can make a direct adjustment to their reserves for zillmerisation, subject to the requirements on mathematical reserves set out in PRU 7.3.43 R, and this is the usual approach. However, where no such adjustment has been made, or where the maximum adjustment has not been made in the mathematical reserves, the FSA will consider an application for an implicit item, if the amount is consistent with the amount that would have been allowed as an adjustment to mathematical reserves under PRU 7.3.43 R.

Hidden reserves

The FSA will grant waivers permitting implicit items due to hidden reserves only in very exceptional circumstances. These items relate to hidden reserves resulting from the underestimation of assets. The rules for the valuation of assets and liabilities (see PRU 1.3) which apply to assets and liabilities other than mathematical reserves are based on the valuation used by the firm for the purposes of its external accounts, with adjustments for regulatory prudence such as concentration limits for large holdings, and would not normally be expected to contain hidden reserves.

Case studies on "unduly burdensome"

Some examples of situations where the existing rules might be considered to be unduly burdensome are given below:

•

A firm writes with-profits business. The firm's investment policy is affected by its published financial position. Application of the rules without an implicit item would result in the firm adopting a lower equity backing ratio. It may be possible to demonstrate that, in the circumstances, it would be unduly burdensome to require the firm to incur costs (which might prejudice policyholders) resulting from the lower equity backing ratio, rather than take allowance for an implicit item.

•

A firm has purchased a block of in-force business, on which the future profits may be reasonably estimated. However, this asset is given no value under the rules. It may be possible to demonstrate that it is unduly burdensome for the firm to recognise the cost of acquiring the assets whilst giving no value to the asset acquired.

•

A firm has a block of in-force business, on which the future profits may be reasonably estimated. Application of the rules without an implicit item would result in a need to obtain additional capital. It may be possible to demonstrate that it is unduly burdensome, having regard to the particular circumstances of the firm, to require it to incur the costs involved in the injection of further capital rather than take allowance for an implicit item.

•

A firm has purchased matching assets for guaranteed annuity liabilities. The operation of the asset and liability valuation rules leads to statutory losses in certain circumstances in spite of good matching of assets and liabilities on a realistic basis of assessment. It may be possible to demonstrate that it is unduly burdensome to require the firm to incur the costs involved in the injection of further capital rather than take allowance for an implicit item.

Conditions which will typically be applied to implicit items waivers

Limits

Where implicit items waivers are granted, the value cannot exceed (and will normally be less than) the monetary limits described in paragraph 27, except that during the transitional period the pre-Solvency I limits will apply. In addition, time limits will apply and waivers will normally only last for 12 months.

Publicity

The FSA will publish the waiver (see SUP 8.6 and SUP 8.7). Public disclosure is standard practice unless the FSA is satisfied that publication is inappropriate or unnecessary (see section 148 of the Act). Any request that a direction not be published should be made to the FSA in writing with grounds in support, as set out in SUP 8.6.
Disclosure of a waiver will normally be required in the firm's annual returns.

31/12/2004

PRU 2 Annex 3

31/12/2004

Annex 3G

This annex provides an illustrative qualitative example of how a small firm could undertake its stress and scenario analysis without this being disproportionate to the size and complexity of its business so as to comply with PRU 1.2.35 R. For these reasons, the example does not provide any quantitative guidance as we believe this would be impractical given the diverse nature of each firm's individual circumstances.

This example is based on guidance contained in PRU 2.3. The areas discussed are not exhaustive and it is likely that in practice a firm will need to consider a range of other issues.

The scenarios that the firm generates as part of its analysis should aim to reflect the degree of risk in a variety of areas. How extreme these scenarios are will influence the ultimate level of capital required by the firm. The firm should not necessarily develop scenarios based on the current trading or economic conditions, but on possible trading or economic conditions that could occur during the next three to five years.

In addition to examining its event scenarios, a firm should also be able to meet any individual risk (however unlikely) that it has accepted (or proposes to accept through its business plan) from policyholders. It therefore should analyse its exposures and ensure that it has sufficient capital or available reinsurance to cover its largest individual risks and accumulations.

Worked example

Background

The firm used for this example is an insurer carrying on general insurance business within a large group, writing predominantly personal lines, household and motor policies of approximately £25m gross written premium. This business has a reasonable geographical spread, sourced significantly from within the United Kingdom. The firm has purchased appropriate reinsurance cover from a variety of reinsurers and has a demonstrated record of utilising this cover. Its settlement pattern for claims averages three years, however, there is a small element of the account with longer tail liability claims. The firm's investments and IT support are outsourced.

Insurance risk

The risk of incorrect or inaccurate pricing of business over the scenario period can be addressed by examining typical uncertainties within the pricing basis and the volatility of claims experience.

In examining the adequacy of its pricing, the firm establishes its underwriting and claims trend over a ten-year base period by reviewing profit and loss accounts (particularly underwriting profit). In particular it examines the following:

(i)

the volatility of losses in a particular line of business;

(ii)

whether the loss ratio exceeded 100% in any line of business; and

(iii)

whether the deferred acquisition cost (DAC) amount had been written down; e.g. whether an unexpired risk provision (URP) was necessary.

The firm also examines whether its premiums over the last ten years have been:

(i)

reasonably stable;

(ii)

responsive enough to changes in claim exposures (so that profitability is maintained);

(iii)

providing adequately for contingencies (such as major losses e.g. hail, earthquake etc);

(iv)

encouraged loss control (through the use of deductibles, no claim bonuses etc);

The firm also reviews its method of pricing. The firm considers and performs the following:

(i)

a review of acceptable rates, e.g. premiums being charged by competitors for similar products;

(ii)

an examination of whether there have been any difficulties in the past with delegated authorities in relation to pricing including the ability and experience of staff members setting or recommending premium prices;

(iii)

an examination of whether the firm has the appropriate mechanisms in place regarding premium rate changes (that is, who makes these decisions, frequency, and on what basis?); and

(iv)

a benchmark price assessment (e.g. the ability to provide adequate competitive premium rates). For example, indicative rates being determined through the use of industry statistics, competitor statistics and the firm's own analysis for all classes.

A10

Other factors the firm considers are:

(i)

changes in environment (e.g. legislation, social, economic etc);

(ii)

changes in policy conditions and deductibles; and

(iii)

impact of market segments (e.g. the effects of different claim frequencies and costs impacting the price charged).

A11

Having completed its analysis, the firm makes the following assumptions to define its underwriting risk:

(i)

claims costs. The firm assumes these are X% higher than in the premium basis;

(ii)

claims inflation. The firm assumes a X% claims inflation over the scenario period, compared to Y% in the pricing basis;

(iii)

policy expenses (fixed and variable) are X% higher than anticipated in the pricing basis;

(iv)

reinsurance charges are X% higher than anticipated in the pricing basis; and

(v)

investment income is X% lower than anticipated in the pricing basis.

As a result of the above analysis on a per risk basis, the firm considers that capital of between £X and £Y would cover the possibility of material deviations to projected results.

Allowing for catastrophes

A12

The allowance for catastrophic events within the insurance risk scenario should reflect both the severity and the frequency of these events.

A13

After considering the catastrophe reinsurance programme it may be clear that the upper limit is set at a level unlikely to be breached e.g. a 1 in 200 year event. Thus, for the purposes of the capital assessment, it would not be necessary to assume losses in excess of this retention.

A14

However, it may be determined that there is possible exhaustion of free reinstatements or of horizontal cover in total. For example, if there were a significant chance of three catastrophic losses in any one period but the reinsurance allowed only one free reinstatement, then the assessment may be to hold two retentions and the entire gross loss for the third event.

As a result of the above analysis, the firm considers it appropriate to hold capital sufficient to absorb three catastrophic losses: one European windstorm of £X, one UK flood of £Y, and one large man made explosion of £Z.

The reinsurance structure in place allows for X number of reinstatements at full premium.

Deterioration of reserves

A15

The firm considers the adequacy of its claims reserves by focussing on the liability valuation.

A16

The liability valuation may contain a range of answers that might indicate possible reserve variability. Also, the valuation will contain areas where judgement has been applied and assumptions formulated which are subjective. These areas are considered and stressed as appropriate.

A17

The firm also reviews the historic level of claims reserves and subsequent level of settlements to help determine the size of any historic levels of under and over reserving.

A18

Reinsurance arrangements are considered and the extent to which these arrangements protect against reserve deterioration is assessed.

A19

For unearned premium, where losses have yet to occur, the firm considers that the level of uncertainty is greater and considers similar factors to those relating to underwriting risk in addition to those discussed above.

As a result of the above analysis, the firm considers it appropriate to apply a X% loading to the outstanding claims provision, a Y% loading to the unearned premium provision and Z% to all other liability values. The firm considers that capital of between £X and £Y would adequately cover reserve deterioration.

Credit risk

A20

Credit risk relates to the risk of default by counterparties. The firm believes its exposure to credit risk results from financial transactions with counterparties including issuers, debtors, borrowers, brokers, policyholders, reinsurers and guarantors.

A21

When assessing credit risk the firm makes an assessment of the creditworthiness of counterparties to the assets of the firm.

A22

The assessment includes an evaluation of the credit risk associated with loans and investment portfolios; the quality of on and off balance sheet assets; the ongoing management of the loans and investment portfolios; as well as loss provisions and reserves.

A23

The firm believes its exposure to credit risk also arises due to its exposure to its reinsurers. In this regard, the firm uses the credit ratings assigned to particular counterparties as a measure of credit risk, most notably Standard & Poor's, Moody's Investors Service and AM Best's (particularly for reinsurers).

A24

When forming an opinion on credit risk the firm considers:

Reinsurance

A25

The firm's strategy is to lessen exposure to a single lead reinsurer to less than 30%, with other participants holding no more than 15%. In all cases, the panel of reinsurers all have a specified rating. The firm has no prior experience of disputes, and their working relationship with the panel may be excellent, and thus the firm does not envisage any future difficulties arising in this regard.

A26

Bond default rates could then be used to assess a likely credit risk figure for reinsurance recoveries (including IBNR recoveries).

The firm considers that capital of between £X and £Y would cover reinsurance defaults, with no additional allowance for disputes.

Overseas financial institutions and banks

A27

The firm investigates its business relationships with overseas financial institution counterparties including banks, and decides no additional allowance is required.

Quality of counterparties and trends in counterparty risk

A28

The firm assesses the level and age of debtors, focussing particularly upon unpaid premiums, especially those greater than three months old, and reviews the level and trend of contingent liabilities. For example, the firm estimates that the credit risk scenario equates to taking a 10% reduction in the asset value of debtors, based on bond default rates and age of debt.

The firm considers that capital of between £X and £Y would cover credit risk to counterparties.

Off-balance sheet transactions

A29

The firm investigates any unfunded commitments, credit derivatives, commercial or standby letters of credit. Where these exist the possibility of a loss on these instruments is considered in relation to the requirement of the credit risk scenario.

The firm considers that no additional capital is necessary.

Market risk

A30

Market risk encompasses an adverse movement in the value of the assets as a consequence of market movements such as interest rates, foreign exchange rates, equity prices, etc. which is not matched by a corresponding movement in the value of the liabilities.

A31

In examining possible market risks, the firm considers its sensitivity to market risk by evaluating the degree to which changes in interest rates, foreign exchange rates, equity prices, or other areas can adversely affect the firm's earnings or capital.

A32

The firm believes its assets and liabilities are approximately matched e.g. there is no existence of large unmatched or unhedged currency positions; short tail business is backed by cash/fixed interest assets of suitable term and long tail business with real assets e.g. shares/property. If mismatching does exist this should be allowed for within the estimate.

A33

In developing the scenario the firm estimates the effect of a X% increase in interest rates on bond values.

A34

Similarly, the firm estimates the effect on equity values of a major recession to estimate the possible reduction in the value of equity capital. Also, it uses a suitable equity index to determine the size of historical falls in equity values and indicate possible future falls.

A35

Counterparty risk might be allowed for by assuming one or several major corporate bond holding defaults.

A36

For all investments, the stability of trading revenues should be examined to determine the volatility of investment.

From the above analysis, the firm considers that capital of between £X and £Y would be appropriate to protect it against adverse movement in market risk.

Liquidity risk

A37

Liquidity risk is the potential that the firm may be unable to meet its obligations as they fall due as a consequence of having a timing mismatch. The firm considers liquidity risk relates to the risk associated with the processes of managing timing relationship between asset and liability cash flow patterns.

A38

When assessing liquidity risk, the firm considers the extent of mismatch between assets and liabilities and the amount of assets held in a highly liquid, marketable form should unexpected cashflows lead to a liquidity crunch.

A39

The price concession of liquidating assets is a prime concern when assessing liquidity risk and is built into the scenario.

A40

In examining the liquidity risk, the firm examines the following:

Marketability, quality and liquidity of assets

A41

The firm considers the assets held and makes an assessment regarding the quality and liquidity of these assets. Even though the assets matched the liabilities, residual risk remains given that timings are uncertain and there is a possibility that assets will be realised at unfavourable times. This is allowed for by assuming a 2.5% reduction in the market value of assets at realisation compared to the current market value.

The firm considers that capital of between £X and £Y would cover timing risk to counterparties.

Reliance on new business income

A42

The firm relies partially upon new business cash flows to meet current liabilities as they fall due. The firm analyses the sensitivity of future cash flow projections and new business assumptions and considers the effect of a reduced level of new business.

A43

The firm finds that it did not have immediate alternatives in place in case these expected new business cash flows were reduced. In this regard, it considers that these sources should be stressed by X%.

The firm considers that capital of between £X and £Y would cover possible effects of adjusting the asset portfolio to switch to more liquid assets.

A44

The firm also examines the volatility and cost of on- and off-balance sheet funding sources. The firm is satisfied that no concerns need to be raised and that there should not be any impact on its liquidity position.

A45

The firm believes it is well placed to manage unplanned changes in funding sources as well as react to changes in market conditions that affect its ability to quickly liquidate assets with minimal loss. The firm assesses that it has reasonable access to money markets and other sources of funding such as lines of credit.

A46

The firm has no previous problems or delays in meeting obligations (or accessing external funding).

Overall, from the above analysis, the firm considers that capital of between £X and £Y would be necessary to withstand the effects of deterioration in liquidity.

Governance Risk

A47

Governance risk relates to the risk associated with the board and/or senior management of the firm not effectively performing their respective roles.

A48

The existence and level of directors and officers insurance in place is investigated compared to known incidence of claims of this type.

A49

The firm assesses whether the current level of governance is appropriate for the firm, and the likelihood that the firm's practices may result in the board and/or senior management not adequately undertaking their roles. The cost of altering and strengthening the current board structure is considered.

A50

In this regard, the firm makes an assessment that it may be reliant on only a few senior executives, and may be exposed if they experience any misadventure.

The firm considers that capital of between £X and £Y would cover governance risk.

Strategic Risk

A51

Strategic risk arises from an inability to implement appropriate business plans and strategies, make decisions, allocate resources or adapt to changes in the business environment.

A52

The firm therefore assesses the prudence and appropriateness of its business strategy in the context of the firm's competitive and economic environment. In particular the assumptions, forecasting and projections are assessed considering the possibility of a fundamental market change due, for example, to higher numbers of competitors, changes in sales channels, new forms of insurance or changes in legislation. This review includes whether the reinsurance programme is appropriate for the risks selected by the firm and whether it adequately takes account of the underwriting and business plans of the firm generally.

A53

The firm considers the likelihood of a fundamental strategic shift too remote to include within the scenario given the maturity of the market in which they operate.

Operational risks

A54

In reviewing the operational risk exposures, the firm has examined its administration, compliance, event, fraud, governance, strategic and technological risks.

Administration

A55

The firm considers the risk of error or failure associated with the administrative aspects of the operation of its business. In this regard, the firm considers likelihood of financial loss and reputation harm due to failure or errors occurring and the likely size of these losses.

A56

None of the firm's administration is out-sourced to service providers.

A57

In undertaking the assessment, the firm considers the history of failure or error from transaction processing or control within the firm. Exception reports are produced on a quarterly basis. Past reports highlighted past administrative deficiencies. The biggest event in the past 10 years related to a situation where claim-handling staff shared access codes to the claims administration system. This resulted in an overpayment to some clients.

A58

The firm also examines the nature and extent of centralised and decentralised functions within the firm. Three branches report regularly to the central office and an appropriate system is in place to record financial information, handle complaints etc.

A59

The firm also reviews the segregation of duties between staff. It is satisfied that an adequate segregation of duties between underwriting claims and payments divisions exist in terms of acceptance, authorisation and payments. It is also satisfied that sufficient interaction between the front, middle and back offices exist in terms of financial control and risk management. For example, it is confident that its guidelines for accepting risks are adequate and that any breach would be picked up by exception reporting.

A60

The firm also investigates the level of staff expertise and training to administer its product range/services.

The firm considers that capital of between £X and £Y would cover the risk of future administration issues.

Compliance Risk

A61

The firm believes its main compliance risk relates to the risk of non-adherence to legislative and internal firm requirements.

A62

An investigation into compliance over the last 10 years finds no history of non-compliance with firm policy and control systems nor have there been any reported areas of non-compliance with legislation or other requirements.

A63

Regulatory reforms including corporate and consumer law are considered and it is assumed that expenses costs will rise as a result of developments in the next 5 years. As a result an additional X% of premium income was assumed for the expense ratio.

The firm considers that capital of between £X and £Y would cover the risk of future compliance issues.

Event risk

A64

Event risk relates to risks associated with the potential impact of significant events (e.g., financial system crisis, major change in fiscal system, natural disaster) on the operations of the firm.

A65

The definition of event risk is not intended to cover events that are directly associated with products and services offered, for example, events which may directly impact on the general insurance business.

A66

The firm concludes that no additional specific allocation is required.

Fraud Risk

A67

Fraud risk relates to the risk associated with intentional misappropriation of funds, undertaken with the objective of personal benefit at the expense of the firm.

A68

In assessing fraud risk, the firm considers the possibility of fraudulent acts occurring within the firm and the extent of controls which management has established to mitigate such acts.

A69

The firm examines fraud issues over a period of 10 years and finds one major incident where it was subject to a fraudulent activity. This involved fraudulent payments being made by a member of staff which resulted in a loss for the firm of £Xm. Based on this previous incident and allowing for improvements in controls, the company assessed a financial figure that it believes is consistent with the probability for this scenario.

The firm considers that capital of between £X and £Y would cover the risk of future fraud.

Technology Risk

A70

The firm considers the risk of error or failure associated with the technological aspects (IT systems) of its operations. Specifically, technology risk refers to both the hardware systems and the software utilised to run those systems.

A71

In relation to the firm's information systems, the firm assesses the past reliability and future functionality and believes them to be adequate. It does not have any future plans to either replace its systems or make major systems modifications.

A72

Concerning business continuity management and disaster recovery planning (and testing of plans), the firm reviews these plans regularly and tests them quarterly. A full back-up site exists with full recovery capabilities. Costs associated with utilising the site and associated business interruption insurance was estimated.

The firm considers that capital of between £X and £Y would cover technology risk.

Group risk

A73

The size of the group risk element within operational risk will depend on the ownership structure of the firm and how it is funded by the parent.

A74

The firm considers the likelihood and financial consequences of both insolvency and credit downgrading of its parent. Given the firm shares the parent's name there is a large risk of association.

A75

The firm considers it within the scope of the scenario to allow for a single downgrade of the parent's credit rating from AA to A. It does not believe the chance of insolvency great enough to allow for directly.

A76

The firm estimates the effect on its business plan and profit margins of the downgrade. It estimates the amount of business lost and the increase in marketing costs required to maintain the client base. It also allows for a change in the pricing basis to incorporate a reduced profit margin (with knock on impacts on the business volume and loss ratios).

From the above analysis, the firm considers that capital of between £X and £Y would be required to cover group risks.

Overall assessment

A77

After individually assessing each risk area, the firm considers the capital that it has estimated might be absorbed under each scenario. In aggregate the range of capital absorbed is between £X and £Y. It considers how many of these scenarios might reasonably occur within a period and the extent to which it could replace capital within that period. It takes into account scenarios which might reasonably be linked, the difficulty with which capital might be replaced if the scenarios occurred, and the changes in strategy which might need to be adopted if the scenarios occurred.

A78

The firm decides that the worst realistic combination of circumstances that might arise would absorb capital of between £A and £B.

31/12/2004