PRU 2

Capital

PRU 2.1

Calculation of capital resources requirements

Application

PRU 2.1.1

See Notes

handbook-rule

PRU 2.1 applies to an insurer unless it is:

PRU 2.1.2

See Notes

handbook-guidance
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.

PRU 2.1.3

See Notes

handbook-rule
  1. (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. (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.

PRU 2.1.4

See Notes

handbook-guidance
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.

PRU 2.1.5

See Notes

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

Purpose

PRU 2.1.6

See Notes

handbook-guidance
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. Through its rules, 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 (see PRU 2.3.2 G to PRU 2.3.3 G).

PRU 2.1.7

See Notes

handbook-guidance

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

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

PRU 2.1.8

See Notes

handbook-guidance
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.

Main requirements

PRU 2.1.9

See Notes

handbook-rule
  1. (1) A firm must maintain at all times capital resources equal to or in excess of its capital resources requirement (CRR).
  2. (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).

PRU 2.1.10

See Notes

handbook-rule
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.

PRU 2.1.11

See Notes

handbook-guidance
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.

PRU 2.1.12

See Notes

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

PRU 2.1.13

See Notes

handbook-guidance
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).

Calculation of the CRR

PRU 2.1.14

See Notes

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

PRU 2.1.15

See Notes

handbook-rule

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

PRU 2.1.16

See Notes

handbook-rule

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. (1) a non-directive mutual;
  2. (2) a firm which has no with-profits insurance liabilities; and
  3. (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.

PRU 2.1.17

See Notes

handbook-rule

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

  1. (1) the firm makes an election that PRU 2.1.15 R is to apply to it; and
  2. (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.

PRU 2.1.18

See Notes

handbook-guidance
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.

PRU 2.1.19

See Notes

handbook-guidance
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.

PRU 2.1.20

See Notes

handbook-rule
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.

Calculation of the MCR

PRU 2.1.21

See Notes

handbook-rule

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

PRU 2.1.22

See Notes

handbook-rule

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

PRU 2.1.23

See Notes

handbook-guidance
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.

PRU 2.1.24

See Notes

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

Calculation of the base capital resources requirement

PRU 2.1.25

See Notes

handbook-rule
The amount of a firm's base capital resources requirement is set out in Table 2.1.26R. If a firm falls within more than one of the descriptions of type of firm set out in Table 2.1.26R, its base capital resources requirement is the highest amount set out against the different types of firm within whose description it falls.

PRU 2.1.26

See Notes

handbook-rule
Table: Base capital resources requirement

PRU 2.1.27

See Notes

handbook-rule
(1) Subject to (1A) to (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.
(1A) In the case of a mutual, the amount of the increased base capital resources requirement will be three-quarters of the amount that would apply if it were not a mutual.
(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 increased amount.

PRU 2.1.28

See Notes

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

PRU 2.1.29

See Notes

handbook-rule
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.

Calculation of the general insurance capital requirement

PRU 2.1.30

See Notes

handbook-rule

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

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

PRU 2.1.31

See Notes

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

Calculation of the long-term insurance capital requirement

PRU 2.1.33

See Notes

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

Calculation of the ECR

PRU 2.1.34

See Notes

handbook-rule

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

PRU 2.1.35

See Notes

handbook-guidance
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.

Monitoring requirements

PRU 2.1.36

See Notes

handbook-rule
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.

PRU 2.1.37

See Notes

handbook-guidance
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.

PRU 2.1.38

See Notes

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

PRU 2.2

Capital resources

Application

PRU 2.2.1

See Notes

handbook-rule

PRU 2.2 applies to an insurer unless it is:

Purpose

PRU 2.2.2

See Notes

handbook-guidance
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.

Principles underlying the definition of capital resources

PRU 2.2.3

See Notes

handbook-guidance
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).

PRU 2.2.4

See Notes

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

Tier one capital

PRU 2.2.5

See Notes

handbook-guidance

Tier one capital typically has the following characteristics:

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

PRU 2.2.6

See Notes

handbook-guidance
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.

Upper and lower tier two capital

PRU 2.2.7

See Notes

handbook-guidance

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. (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); only perpetual capital instruments may be included in upper tier two capital; and
  2. (2) capital which is not perpetual (that is, it has a fixed term) or which may have fixed servicing costs that cannot generally be either waived or deferred, for example, most 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.

Deductions from capital

PRU 2.2.8

See Notes

handbook-guidance
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.

PRU 2.2.9

See Notes

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

Calculation of capital resources

PRU 2.2.10

See Notes

handbook-guidance
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.

PRU 2.2.11

See Notes

handbook-guidance
Table: Approaches to calculating capital resources

PRU 2.2.12

See Notes

handbook-rule
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.

PRU 2.2.13

See Notes

handbook-guidance
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.

PRU 2.2.14

See Notes

handbook-rule
Table: Capital resources (see PRU 2.2.12 R )

Limits on the use of different forms of capital

PRU 2.2.15

See Notes

handbook-guidance
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.

PRU 2.2.16

See Notes

handbook-rule

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

  1. (1) the amount calculated at stage A of the calculation in PRU 2.2.14 R; and
  2. (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.

PRU 2.2.17

See Notes

handbook-rule

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

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

PRU 2.2.18

See Notes

handbook-rule

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

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

PRU 2.2.18A

See Notes

handbook-rule

In PRU 2.2.17 R and PRU 2.2.18 R:

  1. (1) items listed at stage B in PRU 2.2.14 R may be included notwithstanding PRU 2.2.20 R (1);
  2. (2) innovative tier one capital that meets the conditions (other than PRU 2.2.108 R (11)) for it to be included as upper tier two capital at stage G in PRU 2.2.14 R may be treated as an item listed at stage G; and
  3. (3) a firm must exclude from the calculation the higher of the following:
    1. (a) the amount (if any) by which the sum of the items listed at stages G and H in PRU 2.2.14 R exceeds the total (net of deductions) of the remaining constituents of adjusted stage M; and
    2. (b) the amount (if any) by which the sum of the items listed at stage H in PRU 2.2.14 R exceeds one-third of the total (net of deductions) of the remaining constituents of adjusted stage M;
  4. where adjusted stage M means the amount calculated at stage M of the calculation in PRU 2.2.14 R less the amount of any innovative tier one capital that is not treated as upper tier two capital for the purpose of PRU 2.2.17 R or PRU 2.2.18 R, as the case may be.

PRU 2.2.19

See Notes

handbook-guidance
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.

PRU 2.2.20

See Notes

handbook-rule

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

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

PRU 2.2.21

See Notes

handbook-guidance
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.

PRU 2.2.22

See Notes

handbook-rule
  1. (1) A firm may, subject to the limits in PRU 2.2.23 R, include in its tier two capital resources any capital item excluded from its tier one capital resources under PRU 2.2.20 R which meets the conditions for it to be included as tier two capital at stage G or H in PRU 2.2.14 R.
  2. (2) For the purpose of (1), the requirement to obtain a legal opinion in PRU 2.2.108 R (11) does not apply.

PRU 2.2.23

See Notes

handbook-rule

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

  1. (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. (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.

PRU 2.2.24

See Notes

handbook-rule

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

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

PRU 2.2.24A

See Notes

handbook-rule
In PRU 2.2.24 R the amount of any innovative tier one capital that meets the conditions for it to be included as upper tier two capital at stage G in PRU 2.2.14 R may be included in the amount calculated at stage G.

PRU 2.2.25

See Notes

handbook-guidance
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.

PRU 2.2.26

See Notes

handbook-rule
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.

Characteristics of tier one capital

PRU 2.2.27

See Notes

handbook-rule

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

PRU 2.2.28

See Notes

handbook-rule

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

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

PRU 2.2.29

See Notes

handbook-rule

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

  1. (1) it is issued by the firm;
  2. (2) it is fully paid and the proceeds of issue are immediately and fully available to the firm;
  3. (3) it:
    1. (a) cannot be redeemed at all or can only be redeemed on a winding up of the firm; or
    2. (b) complies with the conditions in PRU 2.2.38 R and PRU 2.2.39 R;
  4. (4) any coupon is either non-cumulative or, if it is cumulative, it complies with PRU 2.2.40 R;
  5. (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. (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. (7) the firm is under no obligation to pay a coupon on it in cash at any time; and
  8. (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) and, where it applies, PRU 2.2.93 R.

PRU 2.2.30

See Notes

handbook-rule
  1. (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. (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).

PRU 2.2.31

See Notes

handbook-rule
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).

PRU 2.2.32

See Notes

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

PRU 2.2.33

See Notes

handbook-guidance
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.

PRU 2.2.34

See Notes

handbook-guidance
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.

PRU 2.2.35

See Notes

handbook-rule

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. (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. (2) (in the case of any other firm) it is:
    1. (a) in economic terms; and
    2. (b) in its characteristics as capital (including loss absorbency, permanency, ranking for repayment and fixed costs);
  3. substantially the same as called-up share capital falling into (1).

Core tier one capital: permanent share capital

PRU 2.2.36

See Notes

handbook-rule

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

  1. (1) it is:
    1. (a) an ordinary share; or
    2. (b) a members' contribution; or
    3. (c) part of the initial fund of a mutual;
  2. (2) any coupon on it is not cumulative, and the firm is under no obligation to pay a coupon and has the right to choose the amount of any coupon that it pays; and
  3. (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).

PRU 2.2.37

See Notes

handbook-guidance
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.

Basic rules about redemption and cumulative coupons

PRU 2.2.38

See Notes

handbook-rule

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. (1) it is redeemable only at the option of the firm; and
  2. (2) the firm cannot exercise that redemption right:
    1. (a) before the fifth anniversary of its date of issue;
    2. (b) unless it has given notice to the FSA in accordance with PRU 2.2.72 R; and
    3. (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.

PRU 2.2.39

See Notes

handbook-rule

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

  1. (1) is or may become subject to a step-up; or
  2. (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".

PRU 2.2.40

See Notes

handbook-rule
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.

PRU 2.2.41

See Notes

handbook-guidance
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.

Further guidance on redemption

PRU 2.2.42

See Notes

handbook-guidance

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

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

PRU 2.2.43

See Notes

handbook-guidance

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. (1) PRU 2.2.29 R (3) and PRU 2.2.39 R have the following provisions.
    1. (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.
    2. (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.
    3. (c) Any redemption proceeds should be payable only in cash or in shares.
    4. (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.
    5. (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. (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:
    1. (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
    2. (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. (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.

PRU 2.2.44

See Notes

handbook-guidance
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.

PRU 2.2.45

See Notes

handbook-guidance

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. (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. (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. (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.

Further guidance on coupons

PRU 2.2.46

See Notes

handbook-guidance
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.

PRU 2.2.47

See Notes

handbook-guidance

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. (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. (2) Under PRU 2.2.29 R (7), the firm is not obliged to pay a coupon in cash at any time.
  3. (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. (4) The provisions of PRU 2.2.70 R summarised in PRU 2.2.43 G (2) also apply to the payment of coupons.

PRU 2.2.48

See Notes

handbook-guidance
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. There must be no obligation to pay a coupon and the firm must be able to choose the amount of any coupon paid.

PRU 2.2.49

See Notes

handbook-guidance

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. (1) Under PRU 2.2.60 R a potential tier one instrument with a cumulative coupon is an innovative tier one instrument.
  2. (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. (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.

Perpetual non-cumulative preference shares

PRU 2.2.50

See Notes

handbook-rule

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

  1. (1) it complies with PRU 2.2.29 R, PRU 2.2.35 R and PRU 2.2.38 R;
  2. (2) any coupon on it is not cumulative, and the firm is under no obligation to pay a coupon in any circumstances;
  3. (3) it is not excluded from tier one capital resources by any of the rules in PRU 2.2; and
  4. (4) it is not an innovative tier one instrument.

PRU 2.2.51

See Notes

handbook-guidance
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.

Innovative tier one instruments: general rules

PRU 2.2.52

See Notes

handbook-rule
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.

PRU 2.2.53

See Notes

handbook-rule
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.

PRU 2.2.54

See Notes

handbook-rule

If a tier one instrument:

  1. (1) is redeemable; and
  2. (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:
    1. (a) the firm is likely to redeem it; or
    2. (b) the firm is likely to have a substantial economic incentive to redeem it;
that tier one instrument is an innovative tier one instrument.

PRU 2.2.55

See Notes

handbook-guidance
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.

Innovative tier one instruments: loss absorbency

PRU 2.2.56

See Notes

handbook-rule

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

  1. (1) do not constitute a liability (actual, contingent or prospective) under section 123(2) of the Insolvency Act 1986; or
  2. (2) do constitute such a liability but the terms of the instrument are such that:
    1. (a) any such liability is not relevant for the purposes of deciding whether:
      1. (i) the firm is, or is likely to become, unable to pay its debts; or
      2. (ii) its liabilities exceed its assets;
    2. (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
    3. (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).

PRU 2.2.57

See Notes

handbook-guidance
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.

PRU 2.2.58

See Notes

handbook-rule
A firm wishing to issue an innovative tier one instrument must obtain a properly reasoned legal 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.

PRU 2.2.59

See Notes

handbook-guidance
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.

Innovative tier one instruments: Coupons

PRU 2.2.60

See Notes

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

PRU 2.2.61

See Notes

handbook-guidance
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.

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

PRU 2.2.62

See Notes

handbook-rule

If:

  1. (1) a potential tier one instrument is or may become subject to a step-up; and
  2. (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.

PRU 2.2.63

See Notes

handbook-rule

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 as calculated as at the date of issue of the instrument exceeds or may exceed;

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

PRU 2.2.64

See Notes

handbook-rule
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.

Innovative tier one instruments: principal stock settlement

PRU 2.2.65

See Notes

handbook-rule

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. (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. (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.

PRU 2.2.66

See Notes

handbook-rule

In PRU 2.2.65 R to PRU 2.2.69 R:

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

PRU 2.2.67

See Notes

handbook-rule

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

  1. (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. (2) one unit of the original capital item.

PRU 2.2.68

See Notes

handbook-rule
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.

PRU 2.2.69

See Notes

handbook-rule
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.

Requirement to have sufficient unissued stock

PRU 2.2.70

See Notes

handbook-rule
  1. (1) This rule applies to a potential tier one instrument of a firm where either:
    1. (a) the redemption proceeds; or
    2. (b) any coupon on that capital item;
  2. can be satisfied by the issue of another tier one instrument.
  3. (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):
    1. (a) that are sufficient to satisfy all such payments then due; and
    2. (b) are of such amount as is prudent in respect of such payments that could become due in the future.

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

PRU 2.2.71

See Notes

handbook-rule
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.

PRU 2.2.72

See Notes

handbook-rule
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.

Non standard capital instruments

PRU 2.2.73

See Notes

handbook-guidance
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.

Step-ups

PRU 2.2.74

See Notes

handbook-rule

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. (1) includes (in the case of a fixed rate) an increase in that coupon rate;
  2. (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. (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. (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.

PRU 2.2.75

See Notes

handbook-rule
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.

Profit and loss account and other reserves

PRU 2.2.76

See Notes

handbook-rule
Negative amounts, including any interim net losses, must be deducted from profit and loss account and other reserves.

PRU 2.2.77

See Notes

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

Valuation differences

PRU 2.2.78

See Notes

handbook-rule
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.

PRU 2.2.79

See Notes

handbook-guidance
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) and derecognition of any defined benefit asset in respect of a defined benefit occupational pension scheme (see PRU 1.3.5B 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.

PRU 2.2.80

See Notes

handbook-rule
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.

PRU 2.2.81

See Notes

handbook-rule

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 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. For classes 1 and 2 (other than annuities), if the expected average interval between the settlement date of the claims being discounted and the accounting date is not at least four years, the firm must deduct:

  1. (1) the difference between the undiscounted technical provisions and the discounted technical provisions; or
  2. (2) where it can identify a subset of claims such that the expected average interval between the settlement date of the claims and the accounting date is at least four years, the difference between the undiscounted technical provisions and the discounted technical provisions for the other claims.

Fund for future appropriations

PRU 2.2.81A

See Notes

handbook-rule
The fund for future appropriations means the fund of the same name required by the insurance accounts rules, comprising all funds the allocation of which either to policyholders or to shareholders has not been determined by the end of the financial year, or the balance sheet items under international accounting standards which in aggregate represent as nearly as possible that fund.

Externally verified interim net profits

PRU 2.2.82

See Notes

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

PRU 2.2.83

See Notes

handbook-guidance
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.

Intangible assets

PRU 2.2.84

See Notes

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

PRU 2.2.85

See Notes

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

Inadmissible assets

PRU 2.2.86

See Notes

handbook-rule
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, unless the asset is held to cover property-linked liabilities or index-linked liabilities under PRU 4.2.57 R or PRU 4.2.58 R.

PRU 2.2.87

See Notes

handbook-guidance
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.

PRU 2.2.88

See Notes

handbook-guidance

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

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

Adjustments for related undertakings

PRU 2.2.89

See Notes

handbook-rule
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.

PRU 2.2.90

See Notes

handbook-rule
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.

PRU 2.2.91

See Notes

handbook-guidance
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.

PRU 2.2.92

See Notes

handbook-guidance
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.

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

PRU 2.2.93

See Notes

handbook-rule

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. (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. (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. (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.

PRU 2.2.94

See Notes

handbook-guidance
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.

PRU 2.2.95

See Notes

handbook-guidance
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.

PRU 2.2.96

See Notes

handbook-guidance
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.

PRU 2.2.97

See Notes

handbook-guidance
  1. (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. (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.

Tier two capital

PRU 2.2.98

See Notes

handbook-guidance
Tier two capital resources is split into upper and lower tiers. A major distinction between upper and lower tier two capital is that only 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.

PRU 2.2.99

See Notes

handbook-guidance
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.

Upper tier two capital

PRU 2.2.100

See Notes

handbook-guidance

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

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

PRU 2.2.101

See Notes

handbook-rule

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

  1. (1) it must meet the general conditions described in PRU 2.2.108 R;
  2. (2) it must have no fixed maturity date;
  3. (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;
  4. (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; and
  5. (5) the contractual terms of the instrument must not provide for the instrument to be redeemable or the debt to be repayable on notice from the holder.

PRU 2.2.101A

See Notes

handbook-rule
Where a capital instrument meets PRU 2.2.101 R, and notice of the redemption or repayment of that instrument has been given by the firm in accordance with PRU 2.2.116A R, the firm must no longer include that instrument in its tier two capital resources.

PRU 2.2.102

See Notes

handbook-rule
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.

PRU 2.2.103

See Notes

handbook-rule

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

  1. (1) do not constitute a liability (actual, contingent or prospective) under section 123(2) of the Insolvency Act 1986; or
  2. (2) do constitute such a liability but the terms of the instrument are such that:
    1. (a) any such liability is not relevant for the purposes of deciding whether:
      1. (i) the firm is, or is likely to become, unable to pay its debts; or
      2. (ii) its liabilities exceed its assets;
    2. (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
    3. (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).

PRU 2.2.104

See Notes

handbook-guidance
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.

PRU 2.2.105

See Notes

handbook-rule
A firm wishing to issue an upper tier two instrument other than a perpetual preference share must obtain a properly reasoned legal 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.

PRU 2.2.106

See Notes

handbook-guidance
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.

PRU 2.2.107

See Notes

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

General conditions for eligibility as tier two capital

PRU 2.2.108

See Notes

handbook-rule

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

  1. (1) the claims of the creditors must rank behind those of all unsubordinated creditors;
  2. (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. (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. (4) any events of default and any remedy described in (3) must not prejudice the matters in (1) and (2);
  5. (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) or as permitted by PRU 2.2.116A R or PRU 2.2.123A R;
  6. (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. (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. (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. (9) the debt must be unsecured and fully paid up;
  10. (10) the description of its characteristics used in its marketing is consistent with the characteristics required to satisfy (1) to (9) and, where it applies, PRU 2.2.93 R; and
  11. (11) the firm has obtained a properly reasoned external legal opinion stating that the requirements in (1) to (10) have been met.

PRU 2.2.109

See Notes

handbook-guidance
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).

PRU 2.2.110

See Notes

handbook-guidance
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.

PRU 2.2.111

See Notes

handbook-rule
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.

PRU 2.2.112

See Notes

handbook-guidance
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.

PRU 2.2.113

See Notes

handbook-rule
  1. (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. (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.

PRU 2.2.114

See Notes

handbook-guidance
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.

PRU 2.2.115

See Notes

handbook-guidance
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.

PRU 2.2.116

See Notes

handbook-rule

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

  1. (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. (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.

PRU 2.2.116A

See Notes

handbook-rule
A tier two instrument may be redeemable at the option of the firm, but any contractual term of the instrument providing for the firm to have the right to exercise such an option on a specified date must not provide for that right to be exercisable earlier than the fifth anniversary of the date of issue of the instrument.

PRU 2.2.117

See Notes

handbook-rule
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.

Step-ups

PRU 2.2.118

See Notes

handbook-rule

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

  1. (1) (in the case of a fixed rate) an increase in that rate;
  2. (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.

PRU 2.2.119

See Notes

handbook-rule

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 as calculated as at the date of issue of the instrument is to increase the coupon rate at which payments are to be made by no more than:

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

PRU 2.2.120

See Notes

handbook-rule
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.

PRU 2.2.121

See Notes

handbook-rule
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, any net cost to the firm arising from the different tax treatment of the dividend compared to the tax treatment of interest may be ignored for the purpose of assessing the effect of the step-up.

PRU 2.2.122

See Notes

handbook-guidance
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.

Other conditions for eligibility as lower tier two capital

PRU 2.2.122A

See Notes

handbook-guidance
Capital instruments that meet the general conditions described in PRU 2.2.108 R, including perpetual capital instruments that do not meet one or more of the conditions in PRU 2.2.101 R (3), (4) and (5), may be included in lower tier two capital resources.

PRU 2.2.123

See Notes

handbook-rule
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 it has no fixed maturity date.

PRU 2.2.123A

See Notes

handbook-rule
A lower tier two instrument may include a contractual term providing for the instrument to be redeemable on notice from the holder, but the period of notice of redemption or repayment required to be given by the holder must not be less than five years.

PRU 2.2.124

See Notes

handbook-rule

For the purposes of calculating the amount of a lower tier two instrument which may be included in a firm's capital resources:

  1. (1) in the case of an instrument with a fixed maturity date, in the final five years to maturity; and
  2. (2) in the case of an instrument with or without a fixed maturity date but where five or more years' notice of redemption or repayment has been given, in the final five years to the date of redemption or repayment;

the principal amount must be amortised on a straight line basis.

PRU 2.2.125

See Notes

handbook-guidance
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.

Unpaid share capital or initial funds and calls for supplementary contributions

PRU 2.2.126

See Notes

handbook-guidance
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.

PRU 2.2.127

See Notes

handbook-guidance
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.

PRU 2.2.128

See Notes

handbook-guidance
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 firm's capital resources.

PRU 2.3

Individual Capital Assessment

Application

PRU 2.3.1

See Notes

handbook-rule

PRU 2.3 applies to an insurer unless it is:

Purpose

PRU 2.3.2

See Notes

handbook-guidance
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.

PRU 2.3.3

See Notes

handbook-guidance
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.

PRU 2.3.4

See Notes

handbook-guidance

There are two main purposes of this section:

  1. (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. (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.

Main requirements and guidance

PRU 2.3.5

See Notes

handbook-guidance
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.

PRU 2.3.6

See Notes

handbook-guidance
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.

PRU 2.3.7

See Notes

handbook-guidance
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.

PRU 2.3.8

See Notes

handbook-guidance
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.

PRU 2.3.9

See Notes

handbook-guidance
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.

PRU 2.3.10

See Notes

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

PRU 2.3.11

See Notes

handbook-rule

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:

PRU 2.3.12

See Notes

handbook-guidance
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.

PRU 2.3.13

See Notes

handbook-guidance
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.

PRU 2.3.14

See Notes

handbook-guidance
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.

PRU 2.3.15

See Notes

handbook-guidance
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).

PRU 2.3.16

See Notes

handbook-guidance
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.

PRU 2.3.17

See Notes

handbook-guidance
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.

Stress and scenario requirement

PRU 2.3.18

See Notes

handbook-guidance
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.

Factors to consider when assessing credit risk

PRU 2.3.19

See Notes

handbook-guidance
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.

PRU 2.3.20

See Notes

handbook-guidance

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

  1. (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. (2) the financial effect of non-payment of premium debtors such as intermediaries and policyholders.

PRU 2.3.21

See Notes

handbook-guidance

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

  1. (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. (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. (3) a deterioration in the creditworthiness of the firm's reinsurers, intermediaries or other counterparties;
  4. (4) the degree of credit concentration. For example, the degree to which a firm is exposed to a single counterparty or group;
  5. (5) the degree of concentration of exposure to reinsurers of particular rating grades;
  6. (6) the prospect of reinsurance rates increasing substantially or reinsurance being unavailable;
  7. (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. (8) greater losses from bad debts than anticipated;
  9. (9) deterioration in the extent and quality of collateral; and
  10. (10) guarantees given by the insurer of the performance of others, whether under contracts of insurance or otherwise.

Factors to consider when assessing market risk

PRU 2.3.22

See Notes

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

PRU 2.3.23

See Notes

handbook-guidance

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

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

PRU 2.3.24

See Notes

handbook-guidance

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

  1. (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. (2) unanticipated losses and defaults of issuers;
  3. (3) price shifts in asset classes, and their impact on the entire portfolio;
  4. (4) inadequate valuation of assets;
  5. (5) the direct impact on the portfolio of currency devaluation, as well as the effect on related markets and currencies;
  6. (6) extent of any mismatch of assets and liabilities, including reinvestment risk;
  7. (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. (8) the extent to which market moves could have non-linear effects on values, such as derivatives.

Factors to consider when assessing liquidity risk

PRU 2.3.25

See Notes

handbook-guidance
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.

PRU 2.3.26

See Notes

handbook-guidance

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. (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. (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.

PRU 2.3.27

See Notes

handbook-guidance
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.

PRU 2.3.28

See Notes

handbook-guidance

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

  1. (1) any mismatching between expected asset and liability cash flows;
  2. (2) the inability to sell assets quickly;
  3. (3) the extent to which the firm's assets have been pledged;
  4. (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. (5) the possible need to reduce large asset positions at different levels of market liquidity, and the related potential costs and timing constraints.

Factors to consider when assessing operational risk

PRU 2.3.29

See Notes

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

PRU 2.3.30

See Notes

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

PRU 2.3.31

See Notes

handbook-guidance

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

  1. (1) the likelihood of fraudulent activity occurring that may impact upon the financial or operational aspects of the firm;
  2. (2) the obligation a firm may have to fund a pension scheme for its employees;
  3. (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. (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. (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. (6) the impact of legal risks. For example a non-insurance related legal action being pursued against the firm;
  7. (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. (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.

PRU 2.3.32

See Notes

handbook-guidance
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.

Factors to consider when assessing insurance risk

PRU 2.3.33

See Notes

handbook-guidance

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. (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. (2) determine the likelihood of any other feature of insurance risk that may lead to a variation in projected outcomes.
  3. (3) Firms carrying on general insurance business should in addition:
    1. (a) analyse the potential for claims reserves to deteriorate beyond the current reserving level; and
    2. (b) determine the effect of loss ratios being higher than planned by analysing historic loss ratio experience and volatility.
  4. (4) Firms carrying on long-term insurance business should in addition:
    1. (a) analyse the potential for mathematical reserves subsequently to prove inadequate compared with the current reserving level; and
    2. (b) determine the effect of claims experience being more costly than planned by analysing historic claims experience, volatility and trends in experience.

PRU 2.3.34

See Notes

handbook-guidance

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

  1. (1) For underwriting risks, general insurance business and long-term insurance business firms:
    1. (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;
    2. (b) the uncertainty of claims experience;
    3. (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;
    4. (d) the appropriateness of policy wordings;
    5. (e) the risk of mis-selling, for example, the number of complaints or disputed claims; and
    6. (f) the tolerance for expense reserve variations or variations in expenses (including indirect costs).
  2. (2) For firms carrying on general insurance business, in addition:
    1. (a) the length of tail of the claims development and latent claims; and
    2. (b) the effects of rapid growth or decline in the volume of the underwriting portfolio.
  3. (3) For firms carrying on long-term insurance business, in addition:
    1. (a) the uncertainty of future investment returns;
    2. (b) the effects of rapid growth or decline in the volume and nature of new business written; and
    3. (c) the ability of firms to adjust premium rates or charges for some products.
  4. (4) For reserving and claims risks, both general insurance business and long term insurance business firms:
    1. (a) the frequency and size of large claims;
    2. (b) possible outcomes relating to any disputed claims, particularly where the outcome is subject to legal proceedings;
    3. (c) the ability of the firm to withstand catastrophic events, increases in unexpected exposures, latent claims or aggregation of claims;
    4. (d) the possible exhaustion of reinsurance arrangements, both on a per risk and per event basis;
    5. (e) social changes regarding an increase in the propensity to claim and to sue; and
    6. (f) other social, economic and technological changes.
  5. (5) For firms carrying on general insurance business:
    1. (a) the adequacy and uncertainty of the technical claims provisions, such as outstanding claims, IBNR and claims handling expense reserves;
    2. (b) the adequacy of other underwriting provisions, such as the provisions for unearned premium and unexpired risk reserves;
    3. (c) the appropriateness of catastrophe models and underlying assumptions used, such as possible maximum loss (PML) factors used;
    4. (d) unanticipated legal judgements and legal change with retrospective effect specifically with regard to the claims reserves; and
    5. (e) the effects of inflation.
  6. (6) For firms carrying on long-term insurance business:
    1. (a) the adequacy and sensitivity of the mathematical reserves to variations in future experience, including:
      1. (i) the risk that investment returns differ from those assumed in the reserving assumptions;
      2. (ii) the risk of variations in mortality, morbidity and persistency experience and in the exercise of options under contracts;
      3. (iii) the rates of taxation applied, in particular where there is uncertainty over the tax treatment; and
    2. (b) unanticipated legal judgements and legal change with retrospective effect specifically with regard to the impact on mathematical reserves.

Other assessments of the adequacy of capital resources

PRU 2.3.35

See Notes

handbook-guidance
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.

PRU 2.3.36

See Notes

handbook-guidance
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.

PRU 2.3.37

See Notes

handbook-guidance

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

Control risk factors:

  1. (1) systems and controls.

PRU 2.3.38

See Notes

handbook-guidance
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.

PRU 2.3.39

See Notes

handbook-guidance
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.

PRU 2.3.40

See Notes

handbook-guidance
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.

PRU 2.3.41

See Notes

handbook-guidance
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.

PRU 2.3.42

See Notes

handbook-guidance
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.

PRU 2.3.43

See Notes

handbook-guidance
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.

PRU 2.3.44

See Notes

handbook-guidance
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.

PRU 2.3.45

See Notes

handbook-guidance
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.

PRU 2.3.46

See Notes

handbook-guidance
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.

PRU 2.3.47

See Notes

handbook-guidance

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. (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. (2) a failure by the firm's senior management to approve its financial results; and
  3. (3) a failure by the firm to consider an analysis of relevant internal and external information on its business and control environment.

PRU 2.3.48

See Notes

handbook-guidance
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.

Capital models

PRU 2.3.49

See Notes

handbook-guidance
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.

PRU 2.3.50

See Notes

handbook-guidance
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.

PRU 2.3.51

See Notes

handbook-guidance

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

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

Quantitative factors

PRU 2.3.52

See Notes

handbook-guidance
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.

PRU 2.3.53

See Notes

handbook-guidance

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. (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. (2) five-year predictions as to premium rates in each homogeneous category of business taking account of the effect of underwriting cycles;
  3. (3) predictions of exposures written in each homogeneous category of business in the next five years;
  4. (4) predictions of premium volume and expected growth under a five year business plan;
  5. (5) expenses and commission;
  6. (6) catastrophic events, aggregations of claims and claims affecting more than one class of business;
  7. (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. (8) reinsurance programmes in place, allowing for changing term conditions, reinstatements and loss experience features;
  9. (9) estimates of non-recovery of reinsurance and other debtors taking account of the financial strength of each reinsurance or other counterparty; and
  10. (10) foreign exchange movements.
For firms carrying on general insurance business in particular:
  1. (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;
  2. (12) settlement patterns of claims and reinsurance recoveries for each homogeneous category of business (including occurred and future claims);
  3. (13) unintended coverage of risks; and
  4. (14) correlation between these risks.
  5. For firms carrying on long-term insurance business in particular:
  6. (15) projected claims experience for each homogeneous category of business allowing for trends in mortality/ morbidity experience;
  7. (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
  8. (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.

PRU 2.3.54

See Notes

handbook-guidance
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.

PRU 2.3.55

See Notes

handbook-guidance
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.

PRU 2.3.56

See Notes

handbook-guidance
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.

PRU 2 Annex 1

Admissible assets in insurance

See Notes

handbook-rule

PRU 2 Annex 2

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

See Notes

handbook-guidance

PRU 2 Annex 3

See Notes

handbook-guidance