Credit risk

Part

Integrated Prudential sourcebook

Chapter

Credit risk

Printed on: 16/11/2024

Rulebook at: 21/04/2005

PRU 3

Credit risk

PRU 3.1

Credit risk management systems and controls

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Application

PRU 3.1.1

PRU 3.1 applies to an insurer unless it is:

(1) a non-directive friendly society; or

(2) an incoming EEA firm; or

(3) an incoming Treaty firm.

31/12/2004

PRU 3.1.2

PRU 3.1 applies to:

(1) an EEA-deposit insurer; and
(2) a Swiss general insurer;

only in respect of the activities of the firm carried on from a branch in the United Kingdom.

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Purpose

PRU 3.1.3

This section provides guidance on how to interpret PRU 1.4 insofar as it relates to the management of credit risk.

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PRU 3.1.4

Credit risk is incurred whenever a firm is exposed to loss if another party fails to perform its financial obligations to the firm, including failing to perform them in a timely manner. It arises from both on and off balance sheet items. For contracts for traded financial instruments, for example the purchase and sale of securities or over the counter derivatives, risks may arise if the firm's counterparty does not honour its side of the contract. This constitutes counterparty risk, which can be considered a subset of credit risk. Another risk is issuer risk, which could potentially result in a firm losing the full price of a market instrument since default by the issuer could result in the value of its bonds or stocks falling to nil. In insurance firms, credit risk can arise from premium debtors, where cover under contracts of insurance may either commence before premiums become due or continue after their non-payment. Credit risk can also arise if a reinsurer fails to fulfil its financial obligation to repay a firm upon submission of a claim.

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PRU 3.1.5

Credit risk concerns the FSA in a prudential context because inadequate systems and controls for credit risk management can create a threat to the regulatory objectives of market confidence and consumer protection by:

(1) the erosion of a firm's capital due to excessive credit losses thereby threatening its viability as a going concern;
(2) an inability of a firm to meet its own obligations to depositors, policyholders or other market counterparties due to capital erosion.

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PRU 3.1.6

Appropriate systems and controls for the management of credit risk will vary with the scale, nature and complexity of the firm's activities. Therefore the material in this section is guidance. A firm should assess the appropriateness of any particular item of guidance in the light of the scale, nature and complexity of its activities as well as its obligations as set out in Principle 3 to organise and control its affairs responsibly and effectively.

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Requirements

PRU 3.1.7

High level requirements for prudential systems and controls, including those for credit risk, are set out in PRU 1.4. In particular:

(1) PRU 1.4.19R (2) requires a firm to document its policy for credit risk, including its risk appetite and how it identifies, measures, monitors and controls that risk;
(2) PRU 1.4.19R (2) requires a firm to document its provisioning policy. Documentation should describe the systems and controls that it intends to use to ensure that the policy is correctly implemented;
(3) PRU 1.4.18 R requires it to establish and maintain risk management systems to identify, measure, monitor and control credit risk (in accordance with its credit risk policy), and to take reasonable steps to ensure that its systems are adequate for that purpose;
(4) In line with PRU 1.4.11 G, the ultimate responsibility for the management of credit risk should rest with a firm's governing body. Where delegation of authority occurs the governing body and relevant senior managers should approve and periodically review systems and controls to ensure that delegated duties are being performed correctly.

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Credit risk policy

PRU 3.1.8

PRU 1.4.18 R requires a firm to establish, maintain and document a business plan and risk policies. They should provide a clear indication of the amount and nature of credit risk that the firm wishes to incur. In particular, they should cover for credit risk:

(1) how, with particular reference to its activities, the firm defines and measures credit risk;
(2) the firm's business aims in incurring credit risk including:

(a) identifying the types and sources of credit risk to which the firm wishes to be exposed (and the limits on that exposure) and those to which the firm wishes not to be exposed (and how that is to be achieved, for example how exposure is to be avoided or mitigated);
(b) specifying the level of diversification required by the firm and the firm's tolerance for risk concentrations (and the limits on those exposures and concentrations); and
(c) drawing the distinction between activities where credit risk is taken in order to achieve a return (for example, lending) and activities where credit exposure arises as a consequence of pursuing some other objective (for example, the purchase of a derivative in order to mitigate market risk);

(3) how credit risk is assessed both when credit is granted or incurred and subsequently, including how the adequacy of any security and other risk mitigation techniques is assessed;
(4) the detailed limit structure for credit risk which should:

(a) address all key risk factors, including intra-group exposures and indirect exposures (for example, exposures held by related and subsidiary undertakings);
(b) be commensurate with the volume and complexity of activity;
(c) be consistent with the firm's business aims, historical performance, and its risk appetite;

(5) procedures for:

(a) approving new or additional exposures to counterparties;
(b) approving new products and activities that give rise to credit risk;
(c) regular risk position and performance reporting;
(d) limit exception reporting and approval; and
(e) identifying and dealing with problem exposures caused by the failure or the downgrading of a counterparty;

(6) the methods and assumptions used for the stress testing and scenario analysis required by PRU 1.2 (Adequacy of financial resources), including how these methods and assumptions are selected and tested;
(7) the allocation of responsibilities for implementing the credit risk policy and for monitoring adherence to, and the effectiveness of, the policy.

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Counterparty assessment

PRU 3.1.9

The firm should make a suitable assessment of the risk profile of the counterparty. The factors to be considered will vary according to both the type of credit and the counterparty being considered. This may include:

(1) the purpose of the credit, the duration of the agreement and the source of repayment;
(2) an assessment and continuous monitoring of the credit quality of the counterparty;
(3) an assessment of the claims payment record where the counterparty is a reinsurer;
(4) an assessment of the nature and amount of risk attached to the counterparty in the context of the industrial sector or geographical region or country in which it operates, as well as the potential impact on the counterparty of political, economic and market changes; and
(5) the proposed terms and conditions attached to the granting of credit, including ongoing provision of information by the counterparty, covenants attached to the facility as well as the adequacy and enforceability of collateral, security and guarantees.

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PRU 3.1.10

It is important that sound and legally enforceable documentation is in place for each agreement that gives rise to credit risk as this may be called upon in the event of a default or dispute. A firm should therefore consider whether it is appropriate for an independent legal opinion to be sought on documentation used by the firm. Documentation should normally be in place before the firm enters into a contractual obligation or releases funds.

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PRU 3.1.11

Where premium payments are made via brokers or intermediaries, the firm should describe how it monitors and controls its exposure to those brokers and intermediaries. In particular, the policy should identify whether the risk of default by the broker or intermediary is borne by the firm or the policyholder.

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PRU 3.1.12

Any variation from the usual credit policy should be documented.

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PRU 3.1.13

A firm involved in loan syndications or consortia should not rely on other parties' assessment of the credit risks involved. It will remain responsible for forming its own judgement on the appropriateness of the credit risk thereby incurred with reference to its stated credit risk policy. Similarly a firm remains responsible for assessing the credit risk associated with any insurance or reinsurance placed on its behalf by other parties.

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PRU 3.1.14

Where a credit scoring approach or other counterparty assessment process is used, the firm should periodically assess the particular approach taken in the light of past and expected future counterparty performance and ensure that any statistical process is adjusted accordingly to ensure that the business written complies with the firm's risk appetite.

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PRU 3.1.15

In assessing its contingent exposure to a counterparty, the firm should identify the amount which would be due from the counterparty if the value, index or other factor upon which that amount depends were to change.

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Credit risk measurement

PRU 3.1.16

A firm should measure its credit risk using a robust and consistent methodology which should be described in its credit risk policy; the appropriate method of measurement will depend upon the nature of the credit product provided. The firm should consider whether the measurement methodologies should be backtested and the frequency of such backtesting.

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PRU 3.1.17

A firm should also be able to measure its credit exposure across its entire portfolio or within particular categories such as exposures to particular industries, economic sectors or geographical areas.

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PRU 3.1.18

Where a firm is a member of a group that is subject to consolidated reporting, the group should be able to monitor credit exposures on a consolidated basis. See PRU 8 (Group risk).

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PRU 3.1.19

A firm should have the capability to measure its credit exposure to individual counterparties on at least a daily basis.

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Risk monitoring

PRU 3.1.20

A firm should implement an effective system for monitoring its credit risk which should be described in its credit risk policy.

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PRU 3.1.21

A firm should have a system of management reporting which provides clear, concise, timely and accurate credit risk reports to relevant functions within the firm. The reports could cover exceptions to the firm's credit risk policy, non-performing exposures and changes to the level of credit risk within the firm's credit portfolio. A firm should have procedures for taking appropriate action according to the information within the management reports, such as a review of counterparty limits, or of the overall credit policy.

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PRU 3.1.22

Individual credit facilities and overall limits should be periodically reviewed in order to check their appropriateness for both the current circumstances of the counterparty and the firm's current internal and external economic environment. The frequency of review should be appropriate to the nature of the facility.

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PRU 3.1.23

A firm should utilise appropriate stress testing and scenario analysis of credit exposures to examine the potential effects of economic or industry downturns, market events, changes in interest rates, changes in foreign exchange rates, changes in liquidity conditions and changes in levels of insurance losses where relevant.

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Problem exposures

PRU 3.1.24

A firm should have systematic processes for the timely identification, management and monitoring of problem exposures. These processes should be described in the credit risk policy.

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PRU 3.1.25

A firm should have adequate procedures for recovering exposures in arrears or that have had provisions made against them. A firm should allocate responsibility, either internally or externally, for its arrears management and recovery.

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Provisioning

PRU 3.1.26

PRU 1.4.19R (2) requires a firm to document its provisioning policy. A firm's provisioning policy can be maintained either as a separate document or as part of its credit risk policy.

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PRU 3.1.27

At intervals that are appropriate to the nature, scale and complexity of its activities a firm should review and update its provisioning policy and associated systems.

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PRU 3.1.28

In line with PRU 3.1.6 G, the FSA recognises that the frequency with which a firm reviews its provisioning policy once it has been established will vary from firm to firm. However, the FSA expects a firm to review at least annually whether its policy remains appropriate for the business it undertakes and the economic environment in which it operates.

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PRU 3.1.29

In line with PRU 1.4.12 G, the provisioning policy referred to in PRU 3.1.26 G must be approved by the firm's governing body or another appropriate body to which the firm's governing body has delegated this responsibility.

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PRU 3.1.30

In line with PRU 1.4.24 G, the FSA may request a firm to provide it with a copy of its current provisioning policy.

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PRU 3.1.31

Provisions may be general (against the whole of a given portfolio), specific (against particular exposures identified as bad or doubtful) or both. The FSA expects contingent liabilities (for example guarantees) and anticipated losses to be recognised in accordance with accepted accounting standards at the relevant time, such as those embodied in the Financial Reporting Standards issued by the Accounting Standards Board.

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Risk mitigation

PRU 3.1.32

A firm may choose to use various credit risk mitigation techniques including the taking of collateral, the use of letters of credit or guarantees, or counterparty netting agreements to manage and control their counterparty exposures. The use of such techniques does not obviate the need for thorough credit analysis and procedures. The reliance placed by a firm on risk mitigation should be described in the credit risk policy.

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PRU 3.1.33

A firm should consider the legal and financial ability of a guarantor to fulfil the guarantee if called upon to do so.

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PRU 3.1.34

A firm should monitor the validity and enforceability of its collateral arrangements.

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PRU 3.1.35

The firm should analyse carefully the protection afforded by risk mitigants such as netting agreements or credit derivatives, to ensure that any residual risk is identified, measured, monitored and controlled.

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Record keeping

PRU 3.1.36

Prudential records made under PRU 1.4.53 R should include appropriate records of:

(1) credit exposures, including aggregations of credit exposures, as appropriate, by:

(a) groups of connected counterparties;
(b) types of counterparty as defined, for example, by the nature or geographical location of the counterparty;

(2) credit decisions, including details of the decision and the facts or circumstances upon which it was made; and
(3) information relevant to assessing current counterparty and risk quality.

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PRU 3.1.37

Credit records should be retained as long as they are needed for the purpose described in PRU 3.1.36 G (subject to the minimum three year retention period). In particular, a firm should consider whether it is appropriate to retain information regarding counterparty history such as a record of credit events as well as a record indicating how credit decisions were taken.

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PRU 3.2

Credit risk in insurance

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Application

PRU 3.2.1

PRU 3.2 applies to an insurer unless it is:

(1) a non-directive friendly society; or
(2) an incoming EEA firm; or
(3) an incoming Treaty firm.

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PRU 3.2.2

All of PRU 3.2, except PRU 3.2.20 R and PRU 3.2.23 R to PRU 3.2.32 G, applies to:

(1) an EEA-deposit insurer; and
(2) a Swiss general insurer;

but only in respect of the activities of the firm carried on from a branch in the United Kingdom.

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PRU 3.2.3

The scope of application of PRU 3.2 is not restricted to firms that are subject to relevant EC directives. It applies, for example, to pure reinsurers.

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PRU 3.2.4

(1) This section applies to a firm in relation to the whole of its business, except where a particular provision provides for a narrower scope.
(2) Where a firm carries on both long-term insurance business and general insurance business, this section applies separately to each type of business.

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Purpose

PRU 3.2.5

The purpose of this section is to protect policyholders and potential policyholders by setting out the requirements applicable to a firm in respect of credit risk. Credit risk is incurred whenever a firm is exposed to loss if a counterparty fails to perform its contractual obligations including failure to perform them in a timely manner. Credit risk may therefore have an impact upon a firm's ability to meet its valid claims as they fall due. Credit risk can also arise from underlying causes that have an impact upon the creditworthiness of all counterparties of a particular description or geographical location. A detailed explanation of credit risk is given at PRU 3.1.4 G.

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PRU 3.2.6

The requirements in this section address both current and contingent exposure to credit risk. PRIN, SYSC and PRU 1.4 require a firm to establish adequate internal systems and controls for exposure to credit risk. This section requires a firm to restrict its exposure to different counterparties and assets to prudent levels and to ensure that those exposures are adequately diversified. It also requires a firm to make deductions from the value of assets in respect of exposures to one asset, counterparty or group of closely related counterparties in excess of prescribed limits.

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PRU 3.2.7

This section also sets limits on the market risk arising from holding assets including securities issued or guaranteed by counterparties. This market risk is incurred whenever a firm is exposed to loss if an asset were to reduce in value or even become worthless. These market risk limits are set out in this section rather than the market risk sections in PRU because they are closely linked to the counterparty limits set out in this section.

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Overall limitation of credit risk

PRU 3.2.8

Taking into account relevant risks, a firm must restrict its counterparty exposures and asset exposures to prudent levels and ensure that those exposures are adequately diversified.

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PRU 3.2.9

(1) For the purposes of PRU 3.2, counterparty exposure is the amount a firm would lose if a counterparty were to fail to meet its obligations (either to the firm or to any other person) and if simultaneously securities issued or guaranteed by the counterparty were to become worthless.
(2) For the purposes of PRU 3.2, asset exposure is the amount a firm would lose if an asset or class of identical assets (whether or not held directly by the firm) were to become worthless.
(3) For the purposes of (1) and (2), the amount of loss is the amount, if any, by which the firm's capital resources (as calculated in accordance with PRU 2.2.14 R but without making any deduction for assets in excess of market risk and counterparty limits) would decrease as a result of the counterparty failing to meet its obligations and the securities or assets becoming worthless.
(4) In determining the amount of loss in accordance with (3), the firm must take into account decreases in its capital resources that would result not only from its own direct exposures but also from:

(a) exposures held by any of its subsidiary undertakings; and
(b) synthetic exposures arising from derivatives or quasi-derivatives held or entered into by the firm or any of its subsidiary undertakings.

(5) If a firm elects under PRU 3.2.35 R to make a deduction in respect of collateral, the firm must deduct from the amount of loss determined in accordance with (3) so much of the value of that collateral as:

(a) would be realised by the firm were it to exercise its rights in relation to the collateral; and
(b) does not exceed any of the relevant limits in PRU 3.2.22R (3).

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PRU 3.2.10

Exposure is defined in terms of loss (which is decrease in capital). It does not include exposures arising from assets that are not represented in capital or exposures which if crystallised in a loss would be offset by a consequent gain, reduction in liabilities or release of provisions, but only in so far as that gain, reduction or release would itself lead to an offsetting increase in capital resources. Examples include:

(1) exposure from the holding of assets to which the firm has attributed no value;
(2) exposure from the holding of assets that the firm has deducted from capital resources; and
(3) exposure in respect of which (and to the extent that) the firm has established a provision.

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PRU 3.2.11

In assessing the adequacy of diversification required by PRU 3.2.8 R, a firm should take into account concentrations of exposure including those arising from:

(1) different types of exposure to the same counterparty, such as deposits, loans, securities, reinsurance and derivatives;
(2) links between counterparties such that default by one might have an impact upon the creditworthiness of another; and
(3) possible changes in circumstance that would have an impact upon the creditworthiness of all counterparties of particular description or geographical location.

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PRU 3.2.12

A firm should consider how the spreading of credit risk will impact on overall counterparty quality.

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PRU 3.2.13

In assessing its exposure to a counterparty for the purpose of PRU 3.2.8 R, a firm should take into account:

(1) the period for which the exposure to that counterparty might continue;
(2) the likelihood of default during that period by the counterparty; and
(3) the loss that might result in the event of default.

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PRU 3.2.14

In assessing the loss that might result from the default of a counterparty for the purposes of PRU 3.2.8 R, a firm should take into account the circumstances that might lead to default and, in particular, how these might have an impact upon:

(1) the amount of exposure to the counterparty; and
(2) the effectiveness of any loss mitigation techniques employed by the firm.

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PRU 3.2.15

Often the same circumstances which lead to the crystallisation of contingent credit exposure, e.g. a significant claims event or a significant movement in interest, currency or asset values, also lead to an increase in the risk of default by the counterparty. In particular, if a reinsurer or derivative counterparty is being relied upon to provide protection against the consequences of an event or circumstance, a firm should take into account how that event or circumstance might have an impact upon the creditworthiness of the reinsurer or derivative counterparty.

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PRU 3.2.16

For the purposes of PRU 3.2.8 R and of determining counterparty exposure and asset exposure in accordance with PRU 3.2.9 R and reinsurance exposure in accordance with PRU 3.2.25 R, a firm must only rely upon a loss mitigation technique where it has good reason to believe that, taking into account the possible circumstances of default, it is likely to be effective.

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PRU 3.2.17

Loss mitigation techniques include:

(1) the right, upon default, to preferential access to some or all of the counterparty's assets, for example by exercising rights of set off, holding collateral or assets deposited back, or exercising rights under fixed or floating charges;
(2) rights against third parties upon default by the counterparty, such as guarantees, credit insurance and credit derivatives; and
(3) where the counterparty is a reinsurer, having back-up or flexible reinsurance which covers the gap in coverage left by the reinsurer's default, for example 'top and drop' reinsurance.

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PRU 3.2.18

For the purposes of PRU 3.2.8 R and of determining counterparty exposure and asset exposure in accordance with PRU 3.2.9 R and reinsurance exposure in accordance with PRU 3.2.25 R, a firm must not rely upon preferential access to assets unless it has taken into account appropriate professional advice as to its effectiveness.

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PRU 3.2.19

In particular, a firm should consider whether any preferential access to a counterparty's assets would be effective even if the counterparty were wound up by a court or other legal process or it were to be subject to any other insolvency process. A firm should also consider, where it is relying upon a right against a third party, whether, in the circumstances of the counterparty's default, the creditworthiness of that third party might be impaired.

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Large exposure limits

PRU 3.2.20

(1) A firm must take reasonable steps to limit its counterparty exposure or asset exposure to:

(a) a single counterparty;
(b) each of the counterparties within a group of closely related counterparties; and
(c) an asset or class of identical assets;

to a level where, if a total default were to occur, the firm would not become unable to meet its liabilities as they fall due.
(2) In (1), a total default occurs where:

(a) the single counterparty or all of the counterparties within the group of closely related counterparties fail to meet its or their obligations and simultaneously any securities issued or guaranteed by it or any of them become worthless; or
(b) the asset becomes worthless or all of the assets within the identical class become worthless at the same time.

(3) (1) does not apply to:

(a) a reinsurance exposure; or
(b) a counterparty exposure or asset exposure to an approved credit institution.

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PRU 3.2.21

In assessing its exposure to a counterparty or group of closely related counterparties, a firm should consider exposures from different sources including deposits, loans, securities and derivatives.

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Market risk and counterparty limits

PRU 3.2.22

(1) A firm must calculate the amount of the deduction from total capital required by stage L in the Table in PRU 2.2.14 R in respect of assets in excess of market risk and counterparty limits as the aggregate amount by which its counterparty exposures and asset exposures exceed the relevant limits set out in (3).
(2) Except where the contrary is expressly stated in PRU, whenever:

(a) a rule in PRU refers to assets of a firm, or of any part of a firm, or of any fund or part of a fund within a firm, which are assets of a kind referred to in any of the limits in (3); and
(b) the firm's counterparty exposure (or aggregate exposure arising from the counterparty exposures to each member of a group of closely related persons) or asset exposure in respect of those assets exceeds any of the limits in (3);

the firm must deduct from the measure of the value of those assets (as determined in accordance with PRU 1.3) the amount by which that exposure exceeds the relevant limit in (3), or that portion of the deduction that relates to the part of the firm or fund or part of a fund in question.
(3) The limits referred to in (1) and (2) are the following, expressed as a percentage of the firm's business amount:

(a) for a counterparty exposure to an individual, unincorporated body of individuals or the aggregate exposure arising from the counterparty exposures to each member of a group of closely related individuals or unincorporated bodies of individuals:

(i) ¼% for that part of the exposure that arises from unsecured debt;
(ii) 1% for the whole exposure (after deduction of the excess arising from the limit in (a)(i));

(b) for a counterparty exposure to an approved counterparty or the aggregate exposure arising from the counterparty exposures to each member of a group of closely related approved counterparties:

(i) 5% for that part of the exposure not arising from short term deposits made with an approved credit institution; this limit is increased to 10% if the total of such exposures which exceed 5% is less than 40%;
(ii) 20% or £2 million if larger for the whole exposure (after deduction of the excess arising from the limit in (b)(i));

(c) for a counterparty exposure to a person, or the aggregate exposure arising from the counterparty exposures to each member of a group of closely related persons, who do not fall into the categories of counterparty to whom (a) and (b) apply:

(i) 1% for that part of the exposure arising from unsecured debt; this limit is increased to 2.5% in the case of an exposure to a regulated institution;
(ii) 1% for that part of the exposure arising from shares, bonds, debt securities and other money market instruments and capital market instruments from the same counterparty that are not dealt in on a regulated market, or any beneficial interest in a collective investment scheme which is not a UCITS scheme, a non-UCITS retail scheme or a recognised scheme; the limit for that part of the exposure arising from debt securities (other than hybrid securities) issued by the same regulated institution is increased to 5%;
(iii) 5% for the whole exposure (after deduction of the excesses arising from the limits in (c)(i) and (ii));

(d) 5% for the aggregate of all counterparty exposures that fall within (c)(i) whether or not they arise from persons who are closely related, but excluding amounts that are in excess of the limit in (c)(i);
(e) 10% for the aggregate of all counterparty exposures that fall within (c)(ii) whether or not they arise from persons who are closely related, but excluding amounts that are in excess of the limit in (c)(ii);
(f) 5% for the aggregate of all counterparty exposures arising from unsecured loans, other than those falling within (3)(b);
(g) 3% for the asset exposure arising from all cash in hand;
(h) 10% for the asset exposure (including an exposure arising from a reversionary interest) arising from any one piece of land or building, or a number of pieces of land or buildings close enough to each other to be considered effectively as one investment.

(4) In (3) a firm's business amount means the sum of:

(a) the firm's total gross technical provisions;
(b) the amount of its other liabilities (except those included in the calculation of capital resources in accordance with PRU 2.2.14 R); and
(c) such amount as the firm may select not exceeding the amount of the firm's total capital after deductions as calculated at stage M of the calculation in PRU 2.2.14 R or, if higher:

(i) in the case of a firm carrying on general insurance business, the amount of its general insurance capital requirement; and
(ii) in the case of a firm carrying on long-term insurance business, the amount of its long-term insurance capital requirement and the amount of its resilience capital requirement.

(5) For the purpose of (4)(a), a firm's total gross technical provisions exclude technical provisions in respect of index-linked liabilities or property-linked liabilities, except that where the linked long-term contract of insurance in question includes a guarantee of investment performance or some other guaranteed benefit, the total gross technical provisions include the technical provisions in respect of that guaranteed element.
(6) In (3)(c)(ii) hybrid security means a debt security, other than an approved security, the terms of which provide, or have the effect that, the holder does not, or would not, have an unconditional entitlement to payment of interest and repayment of capital in full within 75 years of the date on which the security is being valued.

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Large exposure calculation for reinsurance exposures

PRU 3.2.23

A firm must notify the FSA in accordance with SUP 15.7 as soon as it first becomes aware that:

(1) a reinsurance exposure to a reinsurer or group of closely related reinsurers is reasonably likely to exceed 100% of its capital resources, excluding capital resources held to cover property-linked liabilities; or
(2) if (1) does not apply, that it has exceeded this limit.

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PRU 3.2.24

Upon notification under PRU 3.2.23 R, a firm must:

(1) demonstrate that prudent provision has been made for the reinsurance exposure in excess of the 100% limit, or explain why in the opinion of the firm no provision is required; and
(2) explain how the reinsurance exposure is being safely managed.

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PRU 3.2.25

(1) For the purposes of PRU 3.2, a reinsurance exposure is the amount of loss which a firm would suffer if a reinsurer or group of closely related reinsurers were to fail to meet its or their obligations under contracts of reinsurance reinsuring any of the firm's contracts of insurance.
(2) For the purposes of (1), the amount of loss is the amount, if any, by which the firm's capital resources (as calculated in accordance with PRU 2.2.14 R but without making any deduction for assets in excess of market risk and counterparty limits) would decrease as a result of the reinsurer or group of closely related reinsurers failing to meet its or their obligations under the contracts of reinsurance.
(3) If a firm elects under PRU 3.2.35 R to make a deduction in respect of collateral, the firm must deduct from the amount of loss determined in accordance with (2) so much of the value of that collateral as:

(a) would be realised by the firm were it to exercise its rights in relation to the collateral; and
(b) does not exceed any of the relevant limits in PRU 3.2.22R (3).

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PRU 3.2.26

A firm must, in determining its reinsurance exposures for the purposes of PRU 3.2, aggregate any reinsurance exposure where the identity of the reinsurer is not known by the firm with the highest reinsurance exposure where it does know the identity of the reinsurer.

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PRU 3.2.27

PRU 3.2.8 R provides that, taking into account relevant risks, a firm must restrict to prudent levels, and adequately diversify, its exposure to counterparties.

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PRU 3.2.28

(1) In each financial year, a firm should restrict the gross earned premiums which it pays to a reinsurer or group of closely related reinsurers to the higher of:

(a) 20% of the firm's projected gross earned premiums for that financial year; or
(b) £4 million.

(2) Compliance with this provision may be relied upon as tending to establish compliance with PRU 3.2.8 R.

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PRU 3.2.29

A firm must notify the FSA immediately in accordance with SUP 15.7 if it has exceeded, or anticipates exceeding, the limit expressed in PRU 3.2.28 E.

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PRU 3.2.30

Upon notification under PRU 3.2.29 R, a firm must explain to the FSA how, despite the excess reinsurance concentration, the credit risk is being safely managed.

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PRU 3.2.31

For the purposes of PRU 3.2.24 R and PRU 3.2.30 R, a firm's explanation of how a reinsurance exposure is being safely managed should also describe the reinsurance market in which the exposure has occurred, and the nature of the reinsurance contract. If appropriate, the firm should also provide a detailed plan and timetable explaining how the excess exposure will be reduced to an acceptable level. The explanation should be approved by a person at the firm of appropriate seniority.

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PRU 3.2.32

Where a firm can demonstrate that the arrangement does not give rise to unacceptable levels of credit risk it is unlikely that further action will be required.

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Exposures excluded from limits

PRU 3.2.33

In PRU 3.2.20 R and PRU 3.2.22 R, references to a counterparty exposure or an asset exposure do not include such an exposure arising from:

(1) a debt which is fully secured on assets whose value at least equals the amount of the debt;
(2) premium debts;
(3) advances secured on, and not exceeding the surrender value of, long-term insurance contracts of the firm;
(4) rights of salvage or subrogation;
(5) deferred acquisition costs;
(6) assets held to cover index-linked liabilities or property-linked liabilities, except that where the linked long-term contract of insurance in question includes a guarantee of investment performance or some other guaranteed benefit, PRU 3.2.20 R and PRU 3.2.22 R will nevertheless apply to assets held to cover that guaranteed element;
(7) moneys due from, or guaranteed by, a Zone A country;
(8) an approved security;
(9) a holding in a UCITS scheme.

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PRU 3.2.34

In PRU 3.2.22 R references to a counterparty exposure or an asset exposure do not include such an exposure arising from reinsurance debts and the reinsurer's share of technical provisions.

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PRU 3.2.35

If:

(1) a firm has a counterparty exposure, an asset exposure or a reinsurance exposure in respect of which it has rights over collateral; and
(2) the assets constituting that collateral would, if owned by the firm, be admissible assets;

the firm may, in determining the amount of that exposure, deduct the value of that collateral in accordance with PRU 3.2.9R (5) or, in the case of a reinsurance exposure, PRU 3.2.25R (3).

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PRU 3.2.36

If a firm has a counterparty exposure, asset exposure or reinsurance exposure the whole or any part of which is:

(1) guaranteed by a credit institution or an investment firm subject in either case to the Capital Adequacy Directive or supervision by a third country (non-EEA) supervisory authority with a Capital Adequacy Directive-equivalent regime; or
(2) adequately mitigated by a credit derivative;

the firm may, for the purposes of PRU 3.2.20 R, PRU 3.2.22 R and PRU 3.2.23 R, treat that exposure, or that part of the exposure which is so guaranteed or mitigated, as an exposure to the guarantor or derivative counterparty, rather than to the original counterparty, asset or reinsurer.

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PRU 3.2.37

For the purposes of PRU 3.2.36 R, references to an exposure being guaranteed include an exposure secured by a letter of credit, but to fall within PRU 3.2.36 R the guarantee or letter of credit must be direct, explicit, unconditional and irrevocable.

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PRU 3.2.38

The portion of exposure which is guaranteed or mitigated by a credit derivative is itself, as an exposure to the guarantor or derivative counterparty, subject to the limits in PRU 3.2.20 R and PRU 3.2.22 R.

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PRU 3.2.39

For the purposes of PRU 3.2.20 R and PRU 3.2.22 R, a UCITS scheme, a non-UCITS retail scheme, a recognised scheme or any other collective investment scheme that invests only in admissible assets (including any derivatives or quasi-derivatives held by the scheme) is to be treated as closely related to the issuer of the units in that scheme.

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Meaning of closely related

PRU 3.2.40

For the purposes of PRU 3.2, a group of persons is closely related if it consists solely of two or more natural or legal persons who, unless it is shown otherwise, constitute a single risk because as between any two of them one or other of the following relationships apply:

(1) one of them, directly or indirectly, has control, as defined in PRU 3.2.41 R, over the other or they are both controlled by the same third party; or
(2) there is no relationship of control as defined in PRU 3.2.41 R but they are to be regarded as constituting a single risk because they are so interconnected that, if one of them were to experience financial problems, the other would be likely to encounter repayment difficulties.

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PRU 3.2.41

For the purposes of PRU 3.2.40 R, control means the relationship between a parent undertaking and a subsidiary undertaking, as defined in Article 1 of the Consolidated Accounts Directive (83/349/EEC), or a similar relationship between any natural or legal person and an undertaking.

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PRU 3.3

Asset-related Capital Requirement

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Application

PRU 3.3.1

PRU 3.3 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.

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PRU 3.3.2

The scope of application of PRU 3.3 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 3.3.3

PRU 3.3 applies to a firm only in relation to its general insurance business.

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PRU 3.3.4

The adequacy of a firm's financial 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 3.3.5

The requirements in PRU 3.3 apply to a firm on a solo basis.

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Purpose

PRU 3.3.6

PRU 2.1.9 R requires that a firm must maintain at all times capital resources equal to or in excess of its capital resources requirement. PRU 2.1.14 R provides that for a firm carrying on general insurance business the firm's capital resources requirement is the Minimum Capital Requirement.

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PRU 3.3.7

The FSA will use the Enhanced Capital Requirement as the benchmark for individual capital guidance for a firm carrying on general insurance business, other than a non-directive insurer. The Enhanced Capital Requirement is the sum of the asset-related capital requirement and the insurance-related capital requirement less the firm's equalisation provisions. This section sets out rules and guidance relating to the asset-related capital requirement. Rules and guidance relating to the insurance-related capital requirement are set out in PRU 7.2.

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PRU 3.3.8

The asset-related capital requirement is a measure of the capital that a firm should hold against the risk of loss if another party fails to perform its financial obligations to the firm or from adverse movements in the value of assets.

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PRU 3.3.9

The asset-related capital requirement is calculated by applying capital charge factors, expressed as a percentage, to different categories of a firm's assets. A firm should refer to PRU 1.3 which sets out how a firm must recognise and value assets and liabilities.

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Calculation of asset-related capital requirement

PRU 3.3.10

A firm must calculate its asset-related capital requirement in accordance with PRU 3.3.11 R.

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PRU 3.3.11

(1) The value of each of the firm's assets of a kind listed in the table in PRU 3.3.16 R must be multiplied by the corresponding capital charge factor.
(2) If any amount which is to be multiplied by a capital charge factor is a negative amount, that amount shall be treated as zero.
(3) No account shall be taken of:

(a) the value of any asset which is not an admissible asset;
(b) the amount (if any) by which the value of any assets exceeds the limits on exposures to a type of asset or counterparty as set out in PRU 3.2.22 R.

(4) Where a firm has entered into a derivative, then for the purposes of applying the appropriate capital charge factor as set out in PRU 3.3.16 R, it must treat the value of the derivative and the value of the asset associated with the derivative as a single asset of a type and value which most closely reflects the economic risk to the firm of the combined rights and obligations associated with the derivative and the asset associated with the derivative.
(5) The amounts resulting from multiplying each of the asset items referred to in (1) by the corresponding capital charge factor must be aggregated.
(6) The asset-related capital requirement is the amount resulting from the aggregation in (5).

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PRU 3.3.12

Options: some derivatives may allow a firm an option whether to buy or sell a particular asset. If an option has a positive market value (that is, in-the-money) it is likely that the firm will exercise the option in the future and the current value of the derivative and associated asset will generally acquire new characteristics and volatility (a 'synthetic asset'). For instance, an option to acquire shares at a price below their current market value is likely to be exercised and the appropriate asset-related capital requirement calculation would be to combine the cash cost of acquiring the number of shares covered by the option with the value of the derivative and apply a factor of 16% to that combined value. If an option has no market value (that is, out-of-the-money) then it is unlikely that a firm would exercise the option in which case the appropriate asset-related capital requirement charge would be zero in respect of the derivative, and the corresponding capital charge contained in Table PRU 3.3.16 R in relation to the asset associated with the derivative.

31/12/2004

PRU 3.3.13

Futures and swaps: futures or swaps may not allow the firm such an option in which case the appropriate asset-related capital charge factor to apply is the one corresponding to the asset that would be held on fulfilment of the contract and the value to which this should be applied would be the value of the asset held after the contract is fulfilled.

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PRU 3.3.14

(1) The asset-related capital charge factor for money market funds set out in the Table PRU 3.3.16 R must be applied to exposures to funds that meet the definition in (2).
(2) In PRU 3.3 an investment in a money market fund means a participation in a collective investment scheme which satisfies the following conditions:

(a) the primary investment objective of the collective investment scheme is:

(i) to maintain the net asset value of the collective investment scheme constant at par (net of earnings); or
(ii) to maintain the net asset value of the collective investment scheme at the value of investors' initial capital plus earnings;

(b) in order to pursue its primary investment objective the collective investment scheme invests exclusively in cash or in short term instruments with characteristics similar to cash or both; and
(c) the collective investment scheme undertakes to abide by the following conditions:

(i) not to allow the assets held in the collective investment scheme to exceed a weighted average maturity of 60 days;
(ii) not to invest in equity or securities with characteristics similar to equity; and
(iii) on a basis of marking-to-market at least weekly, not to permit the value of each collective investment scheme unit at any point in time to move by more than 50 basis points (0.5% of total collective investment scheme value).

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PRU 3.3.15

In PRU 3.3.16 R an insurance dependant means a regulated related undertaking which is an insurance undertaking or an insurance holding company.

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PRU 3.3.16

Table: Asset-related capital charge factors

Asset item

ECR asset-related capital charge factor

Investments

Land and Buildings

7.5%

Investments in group undertakings and participating interests

Shares in group undertakings excluding participating interests

Insurance dependants

Other

7.5%

Debt securities issued by, and loans to, group undertakings

3.5%

Participating interests

7.5%

Debt securities issued by, and loans to, undertakings in which the insurer has a participating interest

3.5%

Other financial investments

Shares and other variable-yield securities and units in unit trusts

16.0%

Money market funds

Debt securities and other fixed income securities

Approved securities

3.5%

Other

3.5%

Participation in investment pools

16.0%

Loans secured by mortgages

2.5%

Other loans

2.5%

Deposits with approved credit institutions and approved financial institutions

Other

7.5%

Deposits with ceding undertakings

3.5%

Reinsurers' share of technical provisions

Provision for unearned premium

2.5%

Claims outstanding

2.5%

Other

2.5%

Debtors

Debtors arising out of direct insurance operations

Policyholders

4.5%

Intermediaries

3.5%

Debtors arising out of reinsurance operations

2.5%

Other debtors

1.5%

Called up share capital not paid

Other Assets

Tangible assets

7.5%

Cash at bank and in hand

Other

Prepayments and accrued income

Accrued interest and rent

Deferred acquisition costs

Other prepayments and accrued income

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