Market risk

Part

PRU Integrated Prudential sourcebook

Chapter

Market risk

Printed on: 08/12/2024

Rulebook at: 01/01/2006

PRU 4

Market risk

PRU 4.1

Market risk management systems and controls

01/10/2005

Application

PRU 4.1.1

PRU 4.1 applies to an insurer unless it is:

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

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PRU 4.1.2

PRU 4.1 applies to:

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

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

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PRU 4.1.3

Firms should also see PRU 1.2 (PRU 1.2.40 G to PRU 1.2.55 G) and PRU 4.2.

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Purpose

PRU 4.1.4

(1) The purpose of this section is to amplify PRU 1.4 insofar as it relates to market risk.
(2) Market risk includes equity, interest rate, FX, commodity risk and interest rate risk on long-term insurance contracts. The price of financial instruments may also be influenced by other risks such as spread risk, basis risk, correlation, specific risk and volatility risk.
(3) This section does not deal with the risk management of market risk in a group context. A firm that is a member of a group should also read PRU 8.1 (Group risk systems and controls) which outlines the FSA's requirements for the risk management of market risk within a group.
(4) Appropriate systems and controls for the management of market risk will vary with the scale, nature and complexity of the firm's activities. Therefore the material in this section is guidance. A firm should assess the appropriateness of any particular item of guidance in the light of the scale, nature and complexity of its activities as well as its obligations as set out in Principle 3 to organise and control its affairs responsibly and effectively.

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Requirements

PRU 4.1.5

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

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

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Market risk policy

PRU 4.1.6

PRU 1.4 requires a firm to establish, maintain and document a business plan and risk policies. They should provide a clear indication of the amount and nature of market risk that the firm wishes to incur. In particular, they should cover for market risk:

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

(a) identifying the types and sources of market risk to which the firm wishes to be exposed (and the limits on that exposure) and those to which the firm wishes not to be exposed (and how that is to be achieved, for example how exposure is to be avoided or mitigated); and
(b) specifying the level of diversification required by the firm and the firm's tolerance for risk concentrations (and the limits on those exposures and concentrations).

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PRU 4.1.7

The market risk policy of a firm should be endorsed by the firm's governing body and implemented by its senior management, who should take adequate steps to disseminate the policy and train the relevant staff such that they can effectively implement the policy.

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PRU 4.1.8

The market risk policy of a firm should enforce the risk management and control principles and include detailed information on:

(1) the financial instruments, commodities, assets and liabilities (and mismatches between assets and liabilities) that a firm is exposed to and the limits on those exposures;
(2) the firm's investment strategy as applicable between each insurance fund;
(3) activities that are intended to hedge or mitigate market risk including mismatches caused by for example differences in the assets and liabilities and maturity mismatches; and
(4) the methods and assumptions used for measuring linear, non-linear and geared market risk including the rationale for selection, ongoing validation and testing. Methods might include stress testing and scenario analysis, option Greeks, asset/liability analysis, correlation analysis and Value-at-Risk (VaR). Exposure to non-linear or geared market risk is typically through the use of derivatives.

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Risk identification

PRU 4.1.9

A firm should have in place appropriate risk reporting systems that enable it to identify the types and amount of market risk to which it is, and potentially could be, exposed. The information that systems should capture may include but is not limited to:

(1) position information which may include a description of individual financial instruments and their cash flows; and
(2) market data which may consist of raw time series of market rates, index levels and prices and derived time series of benchmark yield curves, spreads, implied volatilities, historical volatilities and correlations.

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Risk measurement

PRU 4.1.10

Having identified the market risk that the firm is exposed to on at least a daily basis, a firm should be able to measure and manage that market risk on a consistent basis. This may be achieved by:

(1) regularly stress testing all or parts of the firm's portfolio to estimate potential economic losses in a range of market conditions including abnormal markets. Corporate level stress test results should be discussed regularly by risk monitors, senior management and risk takers, and should guide the firm's market risk appetite (for example, stress tests may lead to discussions on how best to unwind or hedge a position), and influence the internal capital allocation process;
(2) measuring the firm's exposure to particular categories of market risk (for example, equity, interest rate, foreign exchange and commodities) as well as across its entire portfolio of market risks;
(3) analysing the impact that new transactions or businesses may have on its market risk position on an on-going basis; and
(4) regularly backtesting realised results against internal model generated market risk measures in order to evaluate and assess its accuracy. For example, a firm should keep a database of daily risk measures such as VaR and option Greeks, and use these to back test predicted profit and loss against actual profit and loss for all trading desks and business units, and monitor the number of exceptions from agreed confidence bands.

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Valuation

PRU 4.1.11

A firm should take reasonable steps to establish systems and control procedures such that the firm complies with the requirements of PRU 1.3 (Valuation).

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PRU 4.1.12

The systems and controls referred to in PRU 4.1.11 G should include the following:

(1) the department responsible for the validation of the value of assets and liabilities should be independent of the business trading area, and should be adequately resourced by suitably qualified staff. The department should report to a suitably qualified individual, independent from the business trading area, who has sufficient authority to enforce the systems and controls policies and any alterations to valuation treatments where necessary;
(2) all valuations should be checked and validated at appropriate intervals. Where a firm has chosen not to validate all valuations on a daily basis this should be agreed by senior management;
(3) a firm should establish a review procedure to check that the valuation procedures are followed and are producing valuations in compliance with the requirements in this section. The review should be undertaken by suitably qualified staff independent of the business trading area, on a regular and ad hoc basis. In particular, this review procedure should include:

(a) the quality and appropriateness of the price sources used;
(b) valuation reserves held; and
(c) the valuation methodology employed for each product and consistent adherence to that methodology;

(4) where a valuation is disputed and the dispute cannot be resolved in a timely manner it should be reported to senior management. It should continue to be reported to senior management until agreement is reached;
(5) where a firm is marking positions to market it should take reasonable steps to establish a price source that is reliable and appropriate to enable compliance with the provisions in this section on an ongoing basis;
(6) a firm should document its policies and procedures relating to the entire valuation process. In particular, the following should be documented:

(a) the valuation methodologies employed for all product categories;
(b) details of the price sources used for each product;
(c) the procedures to be followed where a valuation is disputed;
(d) the valuation adjustment and reserving policies;
(e) the level at which a difference between a valuation assigned to an asset or liability and the valuation used for validation purposes will be reported on an exceptions basis and investigated;
(f) where a firm is using its own internal estimate to produce a valuation, it should document in detail the process followed in order to produce the valuation; and
(g) the review procedures established by a firm in relation to the requirements of this section should be adequately documented and include the rationale for the policy;

(7) a firm should maintain records which demonstrate:

(a) senior management's approval of the policies and procedures established; and
(b) management sign-off of the reviews undertaken in accordance with PRU 4.1.11 G.

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Risk monitoring

PRU 4.1.13

Risk monitoring is the operational process by which a firm monitors compliance with defined policies and procedures of the market risk policy. The firm's risk monitoring system should be independent of the employees who are responsible for exposing the firm to market risk.

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PRU 4.1.14

The market risk policy of a firm may require the production of market risk reports at various levels within the firm. These reports should provide sufficiently accurate market risk data to relevant functions within the firm, and should be timely enough to allow any appropriate remedial action to be proposed and taken, for example:

(1) at firm wide level, a market risk report may include information:

(a) summarising and commenting on the total market risk that a firm is exposed to and market risk concentrations by business unit, asset class and country;
(b) on VaR reports against risk limits by business unit, asset class and country;
(c) commenting on significant risk concentrations and market developments; and
(d) on market risk in particular legal entities and geographical regions;

(2) at the business unit level, a market risk report may include information summarising market risk by currency, trading desk, maturity or duration band, or by instrument type;
(3) at the trading desk level, a market risk report may include detailed information summarising market risk by individual trader, instrument, position, currency, or maturity or duration band; and
(4) all risk data should be readily reconcilable back to the prime books of entry with a fully documented audit trail.

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PRU 4.1.15

Risk monitoring may also include information on:

(1) the procedures for taking appropriate action in response to the information within the market risk reports;
(2) ensuring that there are controls and procedures for identifying and reporting trades and positions booked at off-market rates;
(3) the process for new product approvals;
(4) the process for dealing with situations (authorised and unauthorised) where particular market risk exposures exceed predetermined risk limits and criteria; and
(5) the periodic review of the risk monitoring process in order to check its suitability for both current market conditions and the firm's overall risk appetite.

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PRU 4.1.16

Risk monitoring should be subject to periodic independent review by suitably qualified staff.

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Risk control

PRU 4.1.17

Risk control is the independent monitoring, assessment and supervision of business units within the defined policies and procedures of the market risk policy. This may be achieved by:

(1) setting an appropriate market risk limit structure to control the firm's exposure to market risk; for example, by setting out a detailed market risk limit structure at the corporate level, the business unit level and the trading desk level which addresses all the key market risk factors and is commensurate with the volume and complexity of activity that the firm undertakes;
(2) setting limits on risks such as price or rate risk, as well as those factors arising from options such as delta, gamma, vega, rho and theta;
(3) setting limits on net and gross positions, market risk concentrations, the maximum allowable loss (also called "stop-loss"), VaR, potential risks arising from stress testing and scenario analysis, gap analysis, correlation, liquidity and volatility; and
(4) considering whether it is appropriate to set intermediate (early warning) thresholds that alert management when limits are being approached, triggering review and action where appropriate.

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Record keeping

PRU 4.1.18

High level requirements for record keeping are set out in PRU 1.4.

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PRU 4.1.19

In relation to market risk, a firm should retain appropriate prudential records of:

(1) off and on market trades in financial instruments;
(2) the nature and amounts of off and on balance sheet exposures, including aggregations of exposures;
(3) trades in financial instruments and other assets and liabilities; and
(4) methods and assumptions used in stress testing and scenario analysis and in VaR models.

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PRU 4.1.20

A firm should keep a data history to enable it to perform back testing of methods and assumptions used for stress testing and scenario analysis and for VaR models.

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PRU 4.2

Market risk in insurance

01/10/2005

Application

PRU 4.2.1

PRU 4.2 applies to an insurer, unless it is:

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

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PRU 4.2.2

The scope of application of PRU 4.2 is not restricted to firms that are subject to the relevant EC directives. It applies, for example, to pure reinsurers (with the exception of PRU 4.2.53 R).

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PRU 4.2.3

(1) PRU 4.2 applies to a firm in relation to the whole of its business, except where a particular provision provides for a narrower scope.
(2) Where a firm carries on both long-term insurance business and general insurance business, PRU 4.2 applies separately to each type of business.

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Purpose

PRU 4.2.4

This section sets out rules and guidance relating to market risk. Under PRU 7.2.20 R and PRU 7.2.21 R, a firm is required to hold admissible assets of a value sufficient to cover its technical provisions and its other long-term insurance or general insurance liabilities. In addition, PRU 7.2.34 R sets the requirement that a firm must hold assets of appropriate amount, currency, term, safety and yield, to ensure that the cash inflows from those assets will be sufficient to meet expected cash outflows from its insurance liabilities as they are due.

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PRU 4.2.5

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

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PRU 4.2.6

A firm may also be exposed to specific market risk, which is the risk that the market value of a specific asset, or income from that asset, may fluctuate for reasons that are not dependent on general market movements. The limits in PRU 3.2.22 R cover market risk as well as counterparty risk.

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PRU 4.2.7

PRU 4.2 addresses the impact of market risk on insurance business in the ways set out below:

(1) Any firm that carries on long-term insurance business must comply with the resilience capital requirement. This requires the firm to hold capital to cover market risk. The resilience capital requirement is dealt with in PRU 4.2.9 G to PRU 4.2.26 R.
(2) For a firm that carries on long-term insurance business, the assets that it must hold must be of a value sufficient to cover the firm's technical provisions and other long-term insurance liabilities. PRU 7.3 contains rules and guidance as to the methods and assumptions to be used in calculating the mathematical reserves. One of these assumptions is the assumed rate of interest to be used in calculating the present value of future payments by or to a firm. PRU 4.2.28 R to PRU 4.2.48 G set out the methodology to be used in relation to long-term insurance liabilities.
(3) Firms carrying on either long-term insurance business or general insurance business are also subject to currency risk. That is, the risk that fluctuations in exchange rates may impact adversely on a firm. PRU 4.2.49 G to PRU 4.2.56 G set out the requirements a firm must meet so as to cover this risk.
(4) For a firm carrying on general insurance business, the Enhanced Capital Requirement already captures some elements of market risk. In addition, the requirements as to the assumed rate of interest used in calculating the present value of general insurance liabilities are contained in the insurance accounts rules, and these requirements are outlined in PRU 4.2.27 G.
(5) Firms carrying on long-term insurance business that have property-linked liabilities or index-linked liabilities must cover these liabilities by holding appropriate assets. PRU 4.2.57 R and PRU 4.2.58 R set out these cover requirements.

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Definitions

PRU 4.2.8

For the purposes of PRU 4.2:

(1) real estate means an interest in land, buildings or other immovable property;
(2) a significant territory is any country or territory in which more than 2.5% of a firm's long-term insurance assets (by market value), excluding assets held to cover index-linked liabilities or property-linked liabilities (see PRU 4.2.57 R and PRU 4.2.58 R), are invested;
(3) the long term gilt yield means the annualised equivalent of the fifteen year gilt yield for the United Kingdom Government fixed-interest securities index jointly compiled by the Financial Times, the Institute of Actuaries and the Faculty of Actuaries; and
(4) the member states of the European Union which have adopted the Euro as the official currency may be treated as a single territory.

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

PRU 4.2.9

The resilience capital requirement forms part of the calculation of the capital resources requirement for all firms carrying on long-term insurance business. PRU 2.1.15 R to PRU 2.1.20 R set out the different elements of this calculation. These include the Minimum Capital Requirement and the Enhanced Capital Requirement. The resilience capital requirement forms part of both of these requirements (see PRU 2.1.22 R (2)and PRU 2.1.34 R (2)).

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PRU 4.2.10

(1) A firm that carries on long-term insurance business must calculate a resilience capital requirement in accordance with (2) to (5).
(2) The firm must identify relevant assets (see PRU 4.2.10A R) which, after applying the scenarios in (3), have a value that is equal to the firm's long-term insurance liabilities under those scenarios.
(3) For the purpose of (2), the scenarios are:

(a) for those relevant assets invested in the United Kingdom, the market risk scenario set out in PRU 4.2.16 R;
(b) subject to (c) and to PRU 4.2.26 R, for those relevant assets invested outside of the United Kingdom, the market risk scenario set out in PRU 4.2.23 R; and
(c) where the relevant assets in (b) are:

(i) held to cover index-linked liabilities or property-linked liabilities; or
(ii) not invested in a significant territory outside the United Kingdom;

the market risk scenario set out in PRU 4.2.16 R.

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

(a) A is the value of the relevant assets which will produce the result described in (2); and
(b) B is the firm's long-term insurance liabilities.

(5) In calculating the value of the firm's long-term insurance liabilities under any scenario, a firm is not required to adjust the provision made under PRU 1.3.5 R in respect of a defined benefits pension scheme.

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PRU 4.2.10A

In PRU 4.2.10 R relevant assets means a range of assets which must be selected by the firm from the assets specified in (1) and (2) in the order specified:

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

(a) to cover its liabilities arising outside its long-term insurance funds; or
(b) to meet any regulatory capital requirements in respect of business written outside its long-term insurance funds.

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PRU 4.2.11

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

(1) the value of long-term insurance liabilities;
(2) the value of assets held to cover long-term insurance liabilities; and
(3) the value of assets held to cover the resilience capital requirement;

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

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PRU 4.2.12

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

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PRU 4.2.13

As part of the assessment of the financial resources a firm needs to hold to comply with PRU 1.2.22 R, PRU 1.2.35 R requires a firm to carry out stress tests and scenario analyses appropriate to the major sources of risk to its ability to meet its liabilities as they fall due identified in accordance with PRU 1.2.31 R. In considering the stress tests and scenario analyses relevant to the major sources of risk in the category of market risk, a firm should consider the extent to which the market risk scenarios set out in PRU 4.2.16 R to PRU 4.2.26 R are appropriate to the nature of its asset portfolio. A firm may judge that given the nature of its portfolio, a more severe stress should be adopted. The firm may also wish to bring in other asset classes, such as index-linked bonds, which should be stressed on appropriate bases, and to consider the impact of currency mismatching and any derivative positions held.

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PRU 4.2.13A

In the market risk scenarios set out in PRU 4.2.16 R to PRU 4.2.26 R, a firm is required to assess the changed value of its assets and liabilities in the economic conditions of the scenarios set out in PRU 4.2.16 R and PRU 4.2.23 R. A firm is required to assess the changed value of each relevant asset (as defined in PRU 4.2.10A R), notwithstanding any uncertainty about the appropriate valuation basis for that asset. In valuing an asset in the specified scenarios, a firm should have regard to the economic substance of the asset, rather than its legal form, and assess its value accordingly. Consider, for example, a convertible bond that is close to its conversion date and where the conversion option has value. The value of the convertible bond in the specified scenarios is likely to be sensitive primarily to equity market scenarios and to a lesser extent to interest rate scenarios. The firm should value the asset according to its expected market value in the economic conditions underlying the specified scenarios.

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PRU 4.2.13B

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

(1) a security dealt in on a regulated market as invested in any country or territory in which a regulated market on which the security is dealt is situated;
(2) a security which is not dealt in on a regulated market as invested in the country or territory in which the issuer has its head office;
(3) an asset consisting of a claim against a debtor as invested in any country or territory where it can be enforced by legal action;
(4) real estate as invested in the country or territory in which the land, buildings or other immovable property is situated;
(5) a tangible asset as invested in the country or territory where it is situated; and
(6) a derivative or quasi-derivative as invested in the country or territory in which the assets to which the firm is exposed by reason of having entered into the derivative or quasi-derivative are situated.

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

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PRU 4.2.14

The resilience capital requirement requires firms to assume different adverse market risk scenarios for equities, real estate and fixed interest securities (see PRU 4.2.16 R and PRU 4.2.23 R) to those required by PRU 7.4.68 R (UK and certain other assets) and PRU 7.4.73 R (non-UK assets) in relation to the calculation of the risk capital margin for a with-profits fund by a realistic basis life firm calculating its with-profits insurance capital component.

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PRU 4.2.15

Where the resilience capital requirement is affected by the presence of derivative or quasi-derivative instruments, the firm will need to consider whether the protection afforded is of suitable length or security. The firm should include the exposure to counterparties in the credit considerations of PRU 4.2.41 R both before and after calculating the resilience capital requirement. If the derivative protection is very short term the firm should consider whether issues arise under PRU 7.3.26 R (Avoidance of future valuation strain); when a derivative expires the financial position of the firm may deteriorate as a result of, for example, falls in asset values. Unless the firm holds a further reserve, the firm is likely to need to have either undertaken a fresh protection strategy or carried through the alternative to the derivative protection (such as selling equities in place of a put option) if the existing protection expires before the financial year end. If the existing derivative protection continues beyond the time of financial year end the firm must have sufficient confidence that it can renew its derivative protection or an alternative to achieve the same effect.

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Market risk scenario for assets invested in the United Kingdom

PRU 4.2.16

In PRU 4.2.10 R (3)(a), the market risk scenario for assets invested in the United Kingdom and for assets (including assets invested outside the United Kingdom) held to cover index-linked liabilities or property-linked liabilities which a firm must assume is:

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

(a) a percentage fall in the market value of equities which would produce an earnings yield on the FTSE Actuaries All Share Index equal to 4/3rds of the long-term gilt yield; and
(b) a fall in the market value of equities of 25% less the equity market adjustment ratio (see PRU 4.2.19 R);

(2) a fall in real estate values of 20% less the real estate market adjustment ratio for an appropriate real estate index (see PRU 4.2.21 R);
(3)

(a) the more onerous of either a fall or rise in yields on all fixed interest securities by the percentage point amount determined in (b);
(b) for the purpose of (a), the percentage point amount is equal to 20% of the long-term gilt yield.

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PRU 4.2.17

For the purposes of PRU 4.2.16 R (1) and PRU 4.2.16R (2), a firm must:

(1) assume that earnings for equities and rack rents for real estate fall by 10%, but dividends for equities remain unaltered (see PRU 4.2.36 R to PRU 4.2.38 R); and
(2) model a fall in equity and real estate markets as if the fall occurred instantaneously.

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PRU 4.2.18

An example of PRU 4.2.16 R (3) is that, where the long-term gilt yield is currently 6%, a firm would assume an increase of 20% in that yield, that is, a change of 1.2 percentage points. For the purpose of the scenario in PRU 4.2.16 R (3)(a), the firm would assume a fall or rise of 1.2 percentage points in yields on all fixed interest securities.

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Equity market adjustment ratio

PRU 4.2.19

The equity market adjustment ratio referred to in PRU 4.2.16 R (1)(b) is:

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

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

(2) 0%, if the ratio calculated in (1)(a) and (b) is more than 100%; and
(3) 25%, if the ratio calculated in (1)(a) and (b) is less than 75%.

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PRU 4.2.20

In PRU 4.2.19 R, the average value of the FTSE Actuaries All Share Index over any period of 90 calendar days means the arithmetic mean based on levels at the close of business on each of the days in that period on which the London Stock Exchange was open for trading.

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Real estate market adjustment ratio

PRU 4.2.21

The real estate market adjustment ratio for a real estate index referred to in PRU 4.2.16 R (2) and PRU 4.2.23 R (2) is:

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

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

(2) 0%, if the ratio calculated in (1)(a) and (b) is more than 100%; and
(3) 10%, if the ratio calculated in (1)(a) and (b) is less than 90%.

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PRU 4.2.22

For the purpose of calculating the real estate market adjustment ratio in PRU 4.2.21 R, a firm should select an appropriate index of real estate values such that:

(1) the constituents of the index are reasonably representative of the nature and territory of the real estate included in the range of assets identified in accordance with PRU 4.2.10 R; and
(2) the frequency of, and historical data relating to, published values of the index are sufficient to enable an average value(s) of the index to be calculated over the three preceding financial years.

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Market risk scenario for assets invested outside the United Kingdom

PRU 4.2.23

In PRU 4.2.10 R (3)(b), subject to PRU 4.2.26 R, the market risk scenario for assets invested outside the United Kingdom (other than assets held to cover index-linked liabilities or property-linked liabilities) which a firm must assume is, for each significant territory in which assets are invested outside the United Kingdom:

(1) an appropriate fall in the market value of equities invested in that territory, which is at least equal to the percentage fall determined in PRU 4.2.16 R;
(2) a fall in real estate values in that territory of 20% less the real estate market adjustment ratio for an appropriate real estate index for that territory (see PRU 4.2.21 R); and
(3)

(a) the more onerous of either a fall or a rise in yields on all fixed interest securities by the percentage point amount determined in (b);
(b) for the purpose of (a), the percentage point amount is equal to 20% of the nearest equivalent (in respect of the method of calculation) to the long term gilt yield.

31/12/2004

PRU 4.2.24

For the purposes of PRU 4.2.23 R (1), an appropriate fall in the market value of equities invested in a significant territory must be determined having regard to:

(1) an appropriate equity market index for that territory; and
(2) the historical volatility of the equity market index selected in (1).

31/12/2004

PRU 4.2.25

For the purpose of PRU 4.2.24 R (1), an appropriate equity market index for a territory is such that:

(1) the constituents of the index are reasonably representative of the nature of the equities held in that territory which are included in the range of assets identified in accordance with PRU 4.2.10 R; and
(2) the frequency of, and historical data relating to, published values of the index are sufficient to enable an average value(s) and historical volatility of the index to be calculated over at least the three preceding financial years.

31/12/2004

PRU 4.2.26

Where the assets of a firm invested in a significant territory of a kind referred to in PRU 4.2.23 R (1), PRU 4.2.23 R (2) or PRU 4.2.23 R (3)(a) represent less than 0.5% of the firm's long-term insurance assets (excluding assets held to cover index-linked liabilities or property-linked liabilities), measured by market value, the firm may assume for those assets the market risk scenario for assets of that kind invested in the United Kingdom set out in PRU 4.2.16 R instead of the market risk scenario set out in PRU 4.2.23 R.

31/12/2004

Interest rates: general insurance liabilities

PRU 4.2.27

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

(1) a rate prudently estimated by the firm to be earned by assets of the firm that are appropriate in magnitude and nature to cover the provisions for claims being discounted, during the period necessary for the payment of such claims;
(2) a rate justified by the performance of such assets over the preceding five years; and
(3) a rate justified by the performance of such assets during the year preceding the balance sheet date.

31/12/2005

Interest rates: long-term insurance liabilities

PRU 4.2.28

The rates of interest required by PRU 7.3.33 R to be used by a firm for the calculation of the present value of a long-term insurance liability must not exceed 97.5% of the risk-adjusted yield (see PRU 4.2.30 R to PRU 4.2.48 G) that is expected to be achieved on:

(1) the assets allocated to cover that liability;
(2) the reinvestment of sums expected to be received from those assets (see PRU 4.2.45 R to PRU 4.2.48 G); and
(3) the investment of future premium receipts (see PRU 4.2.45 R to PRU 4.2.48 G).

31/12/2005

PRU 4.2.29

For the purposes of PRU 4.2.28 R, the rates of interest assumed must allow appropriately for the rates of tax that apply to the investment return on policyholder assets. The rates of tax assumed must be such that the firm's total implied liability for tax arising from the allocation of assets to liabilities is not less than the firm's actual expected liability for tax for the period in respect of which tax is to be assessed.

31/12/2004

Risk-adjusted yield

PRU 4.2.30

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

(1) taking the asset together with any covering derivatives, forward transactions and quasi-derivatives;
(2) assuming that the factors which affect the yield will remain unchanged after the valuation date (see PRU 4.2.33 R);
(3) valuing the asset (together with any offsetting transaction) in accordance with PRU 1.3 (Valuation);
(4) making reasonable assumptions as to whether, and if so when, any options or other rights embedded in the asset (or in any offsetting transaction) will be exercised.

31/12/2004

PRU 4.2.31

Examples of calculating a combined yield for the purposes of PRU 4.2.30 R (1):

(1) 1000 £1 shares (fully paid) of ABC plc covered by a sold future on the shares. Calculating the combined yield effectively results in a position that behaves like cash (with dividend income but no capital gain or loss on the value of the assets); and
(2) where a covering derivative contains an option exercisable by the firm (e.g. a bought put option or receiver swaption), the calculation of the risk adjusted yield should take into account the fact that on the valuation assumptions any time value will reduce over time (known as the 'wasting' nature of the time value of the option), for example, an at-the money option will expire worthless and hence the covering derivative will effectively be a negative yielding asset. There are various ways of allowing for this, for example a firm could treat the covering derivative and the asset as a single asset and calculate an internal rate of return on this combined asset. Alternatively, an explicit reserve could be set up equal and opposite to the time value of the covering derivative which would be written off in the same way as the time value on the covering derivative.

31/12/2004

PRU 4.2.32

The requirements in relation to offsetting transactions are set out in PRU 4.3. The options and other rights referred to in PRU 4.2.30 R (4) include those exercisable by the firm as well as those exercisable by other parties.

31/12/2004

PRU 4.2.33

For the purpose of PRU 4.2.30 R (2), the factors that affect yield should be ascertained as at the valuation date (that is, the date to which present values of cash flows are being calculated). All changes known to have occurred by that date must be taken into account including:

(1) changes in the rental income from real estate;
(2) changes in dividends or audited profit on equities;
(3) known or forecast changes in dividends which have been publicly announced by the issuer by the valuation date;
(4) known or forecast changes in earnings which have been publicly announced by the issuer by the valuation date;
(5) alterations in capital structure; and
(6) the value (at the most recent date at or before the valuation date for which it is known) of any determinant of the amount of any future interest or capital payment.

31/12/2004

PRU 4.2.34

The risk-adjusted yield is either:

(1) (for equities and real estate) a running yield (see PRU 4.2.36 R to PRU 4.2.38 R, PRU 4.2.41 R and PRU 4.2.44 R); or
(2) (for all other assets) the internal rate of return (see PRU 4.2.39 R, PRU 4.2.41 R and PRU 4.2.44 R).

31/12/2004

PRU 4.2.35

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

31/12/2004

The running yield for real estate

PRU 4.2.36

For real estate the running yield is the ratio of:

(1) the rental income arising from the real estate over the previous 12 months; to
(2) the market value of the real estate.

31/12/2004

The running yield for equities

PRU 4.2.37

For equities the running yield is:

(1) the dividend yield, if the dividend yield is more than the earnings yield;
(2) otherwise, the sum of the dividend yield and the earnings yield, divided by two.

31/12/2004

PRU 4.2.38

For the purposes of PRU 4.2.37 R:

(1) the dividend yield is the ratio (expressed as a percentage) of dividend income over the previous 12 months from the equities for which the running yield is being calculated ("the relevant equities") to the market value of those equities;
(2) the earnings yield is the ratio (expressed as a percentage) of the audited profit (including exceptional items and extraordinary items) for the preceding financial year of the issuer of the relevant equities to the market value of those equities;
(3) the earnings yield must be calculated in accordance with whichever is most appropriate (to the issuer of the relevant equities) of United Kingdom, US or international generally accepted accounting practice.

31/12/2004

The internal rate of return

PRU 4.2.39

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

31/12/2004

PRU 4.2.40

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

31/12/2004

Credit risk

PRU 4.2.41

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

31/12/2004

PRU 4.2.42

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

31/12/2004

PRU 4.2.43

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

31/12/2004

PRU 4.2.44

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

31/12/2004

Investment and reinvestment

PRU 4.2.45

Except as provided in PRU 4.2.46 R:

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

(a) the long-term gilt yield;
(b) 3% per annum, increased by two thirds of the excess, if any, of the long-term gilt yield over 3% per annum; and
(c) 6.5% per annum; and

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

31/12/2004

PRU 4.2.46

For the with-profits insurance contracts of a realistic basis life firm, the risk-adjusted yield assumed for the investment or reinvestment of sums denominated in sterling must be no more than rates derived from the forward gilts yield.

31/12/2004

PRU 4.2.47

The risk-adjusted yield assumed for the investment or reinvestment of non-sterling sums must be at least as prudent as in PRU 4.2.45 R and PRU 4.2.46 R.

31/12/2004

PRU 4.2.48

The purpose of PRU 4.2.45 R to PRU 4.2.47 R is to help protect against 'reinvestment risk'. Reinvestment risk is the risk that, when the sums are actually received, interest rates (and so yields available on assets) might have fallen below current expectations.

31/12/2004

Currency risk

PRU 4.2.49

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

(1) has entered into contracts for the purchase or sale of foreign currency; or
(2) has entered into contracts of insurance under which claims are payable in, or determined by reference to a value or price expressed in, a foreign currency; or
(3) holds assets denominated in a foreign currency.

31/12/2004

Cover for spot and forward currency transactions

PRU 4.2.50

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

(1) holding the currency that must be paid by the firm under the contract; or
(2) being subject to an offsetting transaction.

31/12/2004

PRU 4.2.51

The requirements in relation to cover and offsetting transactions are set out in PRU 4.3.

31/12/2004

Currency matching of assets and liabilities

PRU 4.2.52

PRU 7.2.34 R requires a firm to cover its liabilities with assets that enable it to match, in timing, amount and currency, the cash inflows and outflows from those assets and liabilities. This permits some currency mismatching of assets and liabilities, but only if sufficient excess assets are held to cover the exposure arising from such mismatching. The level of permitted currency mismatching is also limited by PRU 4.2.53 R.

31/12/2004

PRU 4.2.53

(1) Subject to PRU 4.2.54 R, a firm must hold admissible assets in each currency of an amount equal to at least 80% of the amount of its liabilities in that currency arising under or in connection with contracts of insurance (but excluding, for a firm that carries on general insurance business, any equalisation provision), except where the amount of those assets does not exceed 7% of the assets in other currencies.
(2) In (1) references to an asset in a currency are to an asset which is expressed in or capable of being realised (without exchange risk) in that currency, and an asset is capable of being so realised if it is reasonably capable of being realised in that currency without risk that changes in exchange rates would reduce the cover for liabilities in that currency.

31/12/2005

PRU 4.2.54

PRU 4.2.53 R does not apply to:

(1) a pure reinsurer; or

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

31/12/2004

PRU 4.2.55

For the purpose of PRU 4.2.53 R, the currency of the liability under a contract of insurance is the currency in which the cover under the contract of insurance is expressed or, if the contract does not specify a currency:

(1) the currency of the country or territory in which the risk is situated; or
(2) if the firm on reasonable grounds so decides, the currency in which the premium payable under the contract is expressed; or
(3) if, taking into account the nature of the risks insured, the firm considers it more appropriate:

(a) the currency (based on past experience) in which it expects the claims to be paid; or
(b) if there is no past experience, the currency of the country or territory in which the firm or relevant branch is established:

(i) for contracts covering risks falling within general insurance business classes 4, 5, 6, 7, 11, 12 and 13 (producer's liability only); and
(ii) for contracts covering risks falling within any other general insurance business class where, in accordance with the nature of the risks, the firm's liabilities are liabilities to be provided in a currency other than that which would result from the application of (1) or (2); or

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

31/12/2004

PRU 4.2.56

The reasonable grounds in PRU 4.2.55 R (2) include if, from the time the contract is entered into, it appears likely that a claim will be paid in the currency of the premium and not in the currency of the country in which the risk is situated.

31/12/2004

Covering linked liabilities

PRU 4.2.57

A firm must cover its property-linked liabilities with:

(1) (as closely as possible) the assets to which those liabilities are linked; or
(2) a property-linked reinsurance contract; or
(3) a combination of (1) and (2).

31/12/2004

PRU 4.2.58

A firm must cover its index-linked liabilities with:

(1) either:

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

(2) a portfolio of assets whose value or yield is reasonably expected to correspond closely with the index-linked liability; or
(3) an index-linked reinsurance contract; or
(4) an index-linked approved derivative; or
(5) an index-linked approved quasi-derivative; or
(6) a combination of any of (1) to (5).

31/12/2004

PRU 4.2.59

For the purposes of PRU 4.2.57 R and PRU 4.2.58 R, a firm is not permitted to hold different assets and to cover the mismatch by holding excess assets.

31/12/2004

PRU 4.2.60

If a firm has incurred a policy liability which cannot be exactly matched by appropriate assets (for example the Limited Price Index (LPI)), the firm should seek to match assets that at least cover the liabilities. For example, an LPI limited to 5% per annum may be matched by an RPI bond or a fixed interest investment matching cash flows increasing at 5% per annum compound.

31/12/2005

PRU 4.2.61

In selecting the appropriate cover, the firm should ensure that both credit risk, and the risk that the value or yield in the assets will not, in all circumstances, match fluctuations in the relevant index, are within acceptable limits. Rules and guidance relating to credit risk are set out in PRU 3.2.

31/12/2004

PRU 4.3

Derivatives in insurance

01/10/2005

Application

PRU 4.3.1

This section applies to an insurer, unless it is:

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

31/12/2004

PRU 4.3.2

The scope of application of PRU 4.3 is not restricted to firms that are subject to the relevant EC directives. It applies, for example, to pure reinsurers.

31/12/2004

PRU 4.3.3

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

31/12/2004

Purpose

PRU 4.3.4

PRU 2.2.12 R requires a firm to calculate its capital resources for the purpose of PRU in accordance with Table PRU 2.2.14 R, subject to the limits in PRU 2.2.16 R to PRU 2.2.26 R. Table PRU 2.2.14 R and PRU 2.2.86 R require a firm to deduct from total capital resources the value of any asset included in an insurance fund which is not an admissible asset as listed in PRU 2 Annex 1R.PRU 2 Annex 1R provides that a derivative, quasi-derivative or stock lending transaction will only be an admissible asset if it is approved. This section sets out the criteria for determining when a derivative, quasi-derivative or stock lending transaction is approved for this purpose. PRU 4.3.5 R to PRU 4.3.35 R set out the criteria for derivatives and quasi-derivatives. PRU 4.3.36 R to PRU 4.3.41 R set out the criteria for stock lending transactions.

31/12/2004

Derivatives and quasi-derivatives

PRU 4.3.5

For the purpose of PRU 2 Annex 1R (Admissible assets in insurance), a derivative or quasi-derivative is approved if:

(1) it is held for the purpose of efficient portfolio management (PRU 4.3.6 R to PRU 4.3.7 R) or reduction of investment risk (PRU 4.3.8 R to PRU 4.3.13 G);
(2) it is covered (PRU 4.3.14 R to PRU 4.3.33 G); and
(3) it is effected or issued:

(a) on or under the rules of a regulated market; or
(b) off-market with an approved counterparty and, except for a forward transaction, on approved terms and is capable of valuation (PRU 4.3.34 R to PRU 4.3.35 R).

31/12/2004

Efficient portfolio management

PRU 4.3.6

A derivative or quasi-derivative is held for the purpose of efficient portfolio management if the firm reasonably believes the derivative or quasi-derivative (either alone or together with any other covered transactions) enables the firm to achieve its investment objectives by one of the following:

(1) generating additional capital or income in one of the ways described in PRU 4.3.7 R; or
(2) reducing tax or investment cost in relation to admissible assets; or
(3) acquiring or disposing of rights in relation to admissible assets, or their equivalent, more efficiently or effectively.

31/12/2004

Generation of additional capital or income

PRU 4.3.7

The generation of additional capital or income falls within PRU 4.3.6 R (1) where it arises from:

(1) taking advantage of pricing imperfections in relation to the acquisition and disposal (or disposal and acquisition) of rights in relation to assets the same as, or equivalent to, admissible assets; or
(2) receiving a premium for selling a covered call option or its equivalent, the underlying of which is an admissible asset, even if that additional capital or income is obtained at the expense of surrendering the chance of greater capital or income.

31/12/2004

Reduction of investment risk

PRU 4.3.8

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

31/12/2004

Significant increase in risk

PRU 4.3.9

For the purposes of PRU 4.3.8 R, an increase in risk from a derivative or quasi-derivative is significant unless:

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

31/12/2004

PRU 4.3.10

PRU 4.3.8 R does not require that a derivative or quasi-derivative has no possible adverse consequences. Often a derivative or quasi-derivative is effected to protect against a severe adverse consequence that only arises in one circumstance. In all other circumstances it may itself lead to adverse consequences, even if only because it expires worthless resulting in the loss of the purchase price. Conversely a derivative or quasi-derivative may reduce risk in a wide range of circumstances but lead to adverse consequences when a particular circumstance arises, e.g. the default of the counterparty. Only rarely does a derivative or quasi-derivative give rise to no adverse consequences in any circumstances. The test is merely that the increase in risk should not be significant, that is it should be both small and reasonable, or the risk should be remote.

31/12/2004

PRU 4.3.11

Firms are reminded that PRU 3.2 (Credit risk in insurance) sets out the different types of loss mitigation techniques.

31/12/2004

Investment risk

PRU 4.3.12

For the purposes of PRU 4.3.8 R, investment risk is the risk that the assets held by a firm:

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

(a) of a value at least equal to the amount of those technical provisions as required by PRU 7.2.20 R; or
(b) of appropriate safety, yield and marketability as required by PRU 7.2.34R (1)(a); or
(c) of an appropriate currency match as required by PRU 4.2.53 R;

(2) (where they are held to cover index-linked liabilities) might not be appropriate cover for those liabilities as required by PRU 4.2.58 R; and
(3) (where they are held to cover property-linked liabilities) might not be appropriately selected in accordance with contractual and constructive liabilities as required by PRU 7.6.36 R and appropriate cover for those liabilities as required by PRU 4.2.57 R.

31/12/2004

PRU 4.3.13

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

(1) a derivative or quasi-derivative that is linked to the same index as the liabilities from the index-linked contracts; and
(2) a derivative or quasi-derivative whose value depends upon the factors which give rise to general insurance claims, e.g. a weather quasi-derivative.

31/12/2004

Cover

PRU 4.3.14

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

(1) a derivative or quasi-derivative; or
(2) a contract (other than a contract of insurance) for the purchase, sale or exchange of assets.

31/12/2004

PRU 4.3.15

An obligation to transfer assets or pay monetary amounts (see PRU 4.3.14 R) must be covered:

(1) by assets, a liability or a provision (see PRU 4.3.16 R to PRU 4.3.24 R); or
(2) by an offsetting transaction (see PRU 4.3.25 R to PRU 4.3.27 R).

31/12/2004

PRU 4.3.16

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

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

31/12/2004

PRU 4.3.17

An obligation to pay a monetary amount (whether or not falling in PRU 4.3.16 R) is covered if:

(1) the firm holds admissible assets that are sufficient in value so that the firm reasonably believes that following reasonably foreseeable adverse variations (relying solely on cashflows from, or from realising, those assets) it could pay the monetary amount in the right currency when it falls due; or
(2) the obligation to pay the monetary amount is offset by a liability. An obligation is offset by a liability where an increase in the amount of that obligation would be offset by a decrease in the amount of that liability; or
(3) a provision at least equal to the value of the assets in (1) is implicitly or explicitly set up. A provision is implicitly set up to the extent that the obligation to pay the monetary amount is recognised under PRU 1.3 (Valuation) either by offset against an asset or as a separate liability. A provision is explicitly set up if it is in addition to an implicit provision.

31/12/2004

PRU 4.3.18

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

31/12/2004

PRU 4.3.19

Where a firm partially covers a derivative (or other contract falling within PRU 4.3.14 R (1) and PRU 4.3.14R (2)), the firm may split the derivative into a covered portion and an uncovered portion. The portion of the derivative that is covered (after taking into account the requirement to cover reasonably foreseeable adverse variations in PRU 4.3.17 R (1)) is an approved derivative, provided it also meets the requirements in PRU 4.3.5 R (1) and PRU 4.3.5 R (3); the uncovered portion is not an approved derivative.

31/12/2004

PRU 4.3.20

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

31/12/2004

PRU 4.3.21

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

31/12/2004

PRU 4.3.22

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

31/12/2004

PRU 4.3.23

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

31/12/2004

PRU 4.3.24

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

31/12/2004

Offsetting transactions

PRU 4.3.25

An offsetting transaction means:

(1) an approved derivative, approved stock lending transaction or an approved quasi-derivative; or
(2) a covered transaction with an approved counterparty for the purchase of assets.

31/12/2004

PRU 4.3.26

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

31/12/2004

PRU 4.3.27

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

31/12/2004

Lending and borrowing assets

PRU 4.3.28

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

(1) they are non-monetary assets that have been lent under a transaction that fulfils the conditions in PRU 4.3.36 R; and
(2) the firm reasonably believes the assets to be obtainable (by return or re-acquisition) in time to meet the obligation for which cover is required.

31/12/2004

PRU 4.3.29

Assets that have been borrowed by the firm are not available for cover except as allowed by PRU 4.3.30 R.

31/12/2004

PRU 4.3.30

Borrowed money may be used as cover only where:

(1) the money has been advanced or an approved credit institution has committed itself to advance the money; and
(2) the borrowing is or would be covered.

31/12/2004

PRU 4.3.31

PRU 4.3.30 R in effect allows borrowings to be used to bridge the gap between an obligation under a transaction that might fall due at one date and cash or its equivalent that would only become due at a later date. Borrowings may not be used to gear the investment portfolio.

31/12/2004

Examples of cover requirements

PRU 4.3.32

Examples of cover by assets for the purposes of PRU 4.3.16 R:

(1) a bought put option (or a sold call option) on 1000 £1 shares (fully paid) of ABC plc is covered by an existing holding in the fund of 1000 £1 shares (fully paid) of ABC plc;
(2) a bought call option (or sold put option) on 1000 ordinary £1 shares (fully paid) of ABC plc is covered by cash (or its equivalent) which is sufficient in amount to meet the purchase price of the shares on exercise of the option;
(3) a bought or sold contract for differences on short-dated sterling is covered by cash (or its equivalent), the value of which together at least match the notional principal of the contract. For example, a LIFFE short sterling contract, or a successive series of such contracts, is covered by £500,000; and
(4) a sold future on the FT-SE 100 index is covered by holdings of equities, which satisfy the reasonable approximation test for cover in PRU 4.3.16 R (2) in relation to that future, and the values of which together at least match the current mark to market valuation of the future. For example, if the multiplier per full point is £10, and if the eventual obligation under the future is currently 2800, the valuation of the futures position is 2800 x £10 = £28,000.

31/12/2004

PRU 4.3.33

Examples of cover by offsetting transactions for the purpose of PRU 4.3.25 R would include a bought future which is guaranteed to deliver to the firm at the relevant time sufficient assets to cover liabilities under a sold call option.

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Off-market transactions

PRU 4.3.34

For the purpose of PRU 4.3.5 R (3)(b), a transaction is on approved terms only if the counterparty has agreed to enter into a further transaction to close out the first transaction at a price based on current market conditions.

31/12/2004

PRU 4.3.35

A transaction is capable of valuation only if the firm, throughout the life of the transaction, will be able to value it with reasonable accuracy on a reliable basis reflecting an up-to-date mark-to-market value.

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Stock lending

PRU 4.3.36

(1) For the purposes of PRU 2 Annex 1 R (Admissible assets in insurance), a stock lending transaction is approved if:

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

(i) the Office of the Comptroller of the Currency;
(ii) the Federal Deposit Insurance Corporation;
(iii) the Board of Governors of the Federal Reserve System; and
(iv) the Office of Thrift Supervision; and

(c) adequate and sufficiently immediate collateral (PRU 4.3.38 R to PRU 4.3.41 R) is obtained to secure the obligation of the counterparty.

(2) PRU 4.3.36 R (1)(c) does not apply to a stock lending transaction made through Euroclear Bank SA/NV's Securities Lending and Borrowing Programme.

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PRU 4.3.37

PRU 4.3.36 R refers only to stock lending transactions where the firm is the lender. There are no special rules for a transaction under which the firm borrows securities.

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Collateral

PRU 4.3.38

For the purposes of PRU 4.3.36 R (1)(c), collateral is adequate only if it:

(1) is transferred to the firm or its agent or, in the case of a letter of credit, meets the conditions described in PRU 4.3.38A R;
(2) is, at the time of the transfer or, in the case of a letter of credit, at the time of issue, at least equal in value to the value of the securities transferred, or consideration provided, by the firm; and
(3) is of adequate quality.

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PRU 4.3.38A

The conditions referred to in PRU 4.3.38 R (1) are that the letter of credit is:

(1) direct, explicit, unconditional and irrevocable; and
(2) issued by an undertaking which is:

(a) not a related undertaking of the counterparty; and
(b) either an approved credit institution or a bank, or a branch of a bank, whether chartered by the federal government of the United States of America or a US state, that is supervised and examined by at least one of the following US federal banking supervisory authorities:

(i) the Office of the Comptroller of the Currency;
(ii) the Federal Deposit Insurance Corporation;
(iii) the Board of Governors of the Federal Reserve System; and
(iv) the Office of Thrift Supervision.

31/12/2005

PRU 4.3.39

For the purposes of assessing adequate quality in PRU 4.3.38 R (3), reference should be made to the criteria for credit risk loss mitigation set out in PRU 3.2.16 R. The valuation rules in PRU 1.3 apply for the purpose of determining the value of both collateral received, and the securities transferred, by the firm. In addition, where collateral takes the form of assets transferred, under the rules in PRU any such asset that is not an admissible asset (see PRU 2 Ann 1R) does not have a value.

31/12/2005

PRU 4.3.40

For the purposes of PRU 4.3.36 R (1)(c), collateral is sufficiently immediate only if:

(1) it is transferred or, in the case of a letter of credit, issued before, or at the same time as, the transfer of the securities by the firm; or
(2) it will be transferred or, in the case of a letter of credit, issued, at latest, by the close of business on the day of the transfer.

31/12/2005

PRU 4.3.41

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

31/12/2005

PRU 4.3.42

References in PRU 4.3.40 R (2) and PRU 4.3.41 R to the close of business on the day of the transfer or the day of expiry are to close of business on that day in all time regions.

31/12/2005