Insurance risk

Part

PRU Integrated Prudential sourcebook

Chapter

Insurance risk

Printed on: 30/12/2024

Rulebook at: 31/12/2005

PRU 7

Insurance risk

PRU 7.1

Insurance risk systems and controls

01/10/2005

Application

PRU 7.1.1

PRU 7.1 applies to an insurer unless it is:

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

31/12/2004

PRU 7.1.2

PRU 7.1 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.

31/12/2004

Purpose

PRU 7.1.3

This section provides guidance on how to interpret PRU 1.4 (Prudential risk management and associated systems and controls) in so far as it relates to the management of insurance risk. Insurance risk refers to fluctuations in the timing, frequency and severity of insured events, relative to the expectations of the firm at the time of underwriting. Insurance risk can also refer to fluctuations in the timing and amount of claim settlements. For general insurance business some specific examples of insurance risk include variations in the amount or frequency of claims or the unexpected occurrence of multiple claims arising from a single cause. For long-term insurance business examples include variations in the mortality and persistency rates of policyholders, or the possibility that guarantees could acquire a value that adversely affects the finances of a firm and its ability to treat its policyholders fairly consistent with the firm's obligations under Principle 6. More generally, insurance risk includes the potential for expense overruns relative to pricing or provisioning assumptions.

31/12/2004

PRU 7.1.4

Insurance risk concerns the FSA in a prudential context because inadequate systems and controls for its management can create a threat to the regulatory objectives of market confidence and consumer protection. Inadequately managed insurance risk may result in:

(1) the inability of a firm to meet its contractual insurance liabilities as they fall due; and
(2) the inability of a firm to treat its policyholders fairly consistent with the firm's obligations under Principle 6 (for example, in relation to bonus payments).

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PRU 7.1.5

Guidance on the application of this section to a firm that is a member of a group is provided in PRU 8.1 (Group risk systems and controls).

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PRU 7.1.6

The guidance contained within this section should be read in conjunction with SYSC and PRU 1.4.

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PRU 7.1.7

Appropriate systems and controls for the management of insurance risk will vary with the scale, nature and complexity of a 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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General requirements

PRU 7.1.8

High level rules and guidance for prudential systems and controls for insurance risk are set out in PRU 1.4. In particular:

(1) PRU 1.4.18 R requires a firm to take reasonable steps to establish and maintain a business plan and appropriate risk management systems;
(2) PRU 1.4.19R (2) requires a firm to document its policy for insurance risk, including its risk appetite and how it identifies, measures, monitors and controls that risk; and
(3) PRU 1.4.27 R requires a firm to take reasonable steps to establish and maintain adequate internal controls to enable it to assess and monitor the effectiveness and implementation of its business plan and prudential risk management systems.

31/12/2004

Insurance risk policy

PRU 7.1.9

A firm's insurance risk policy should outline its objectives in carrying out insurance business, its appetite for insurance risk and its policies for identifying, measuring, monitoring and controlling insurance risk. The insurance risk policy should cover any activities that are associated with the creation or management of insurance risk. For example, underwriting, claims management and settlement, assessing technical provisions in the balance sheet, risk mitigation and risk transfer, record keeping and management reporting. Specific matters that should normally be in a firm's insurance risk policy include:

(1) a statement of the firm's willingness and capacity to accept insurance risk;
(2) the classes and characteristics of insurance business that the firm is prepared to accept;
(3) the underwriting criteria that the firm intends to adopt, including how these can influence its rating and pricing decisions;
(4) its approach to limiting significant aggregations of insurance risk, for example, by setting limits on the amount of business that can be underwritten in one region or with one policyholder;
(5) where relevant, the firm's approach to pricing long-term insurance contracts, including the determination of the appropriate level of any reviewable premiums;
(6) the firm's policy for identifying, monitoring and managing risk when it has delegated underwriting authority to another party (additional guidance on the management of outsourcing arrangements is provided in SYSC 3A.9);
(7) the firm's approach to managing its expense levels, including acquisition costs, recurring costs, and one-off costs, taking account of the margins available in both the prices for products and in the technical provisions in the balance sheet;
(8) the firm's approach to the exercise of any discretion (e.g. on charges or the level of benefits payable) that is available in its long-term insurance contracts, in the context also of the legal and regulatory constraints existing on the application of this discretion;
(9) the firm's approach to the inclusion of options within new long-term insurance contracts and to the possible exercise by policyholders of options on existing contracts;
(10) the firm's approach to managing persistency risk;
(11) the firm's approach to managing risks arising from timing differences in taxation or from changes in tax laws;
(12) the firm's approach to the use of reinsurance or the use of some other means of risk transfer;
(13) how the firm intends to assess the effectiveness of its risk transfer arrangements and manage the residual or transformed risks (for example, how it intends to handle disputes over contract wordings, potential payout delays and counterparty performance risks);
(14) a summary of the data and information to be collected and reported on underwriting, claims and risk control (including internal accounting records), management reporting requirements and external data for risk assessment purposes;
(15) the risk measurement and analysis techniques to be used for setting underwriting premiums, technical provisions in the balance sheet, and assessing capital requirements; and
(16) the firm's approach to stress testing and scenario analysis, as required by PRU 1.2 (Adequacy of financial resources), including the methods adopted, any assumptions made and the use that is to be made of the results.

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PRU 7.1.10

Further, more detailed, guidance is given in PRU 7.1.11 G to PRU 7.1.37 G on the identification, measurement, monitoring and control (including the use of reinsurance and other forms of risk transfer) of insurance risk. A firm should consider what additional material to that set out above should be included in its insurance risk policy on each of these for its various activities.

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Risk identification

PRU 7.1.11

A firm should seek to identify the causes of fluctuations in the occurrence, amount and timing of its insurance liabilities. A firm should also seek to identify aggregations of risk that may give rise to large single or multiple claims.

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PRU 7.1.12

The identification of insurance risk should normally include:

(1) in connection with the firm's business plan:

(a) processes for identifying the types of insurance risks that may be associated with a new product and for comparing the risk types that are present in different classes of business (in order to identify possible aggregations in particular insurance risks); and
(b) processes for identifying business environment changes (for example landmark legal rulings) and for collecting internal and external data to test and modify business plans;

(2) at the point of sale, processes for identifying the underwriting risks associated with a particular policyholder or a group of policyholders (for example, processes for identifying potential claims for mis-selling and for collecting information on the claims histories of policyholders, including whether they have made any potentially false or inaccurate claims, to identify possible adverse selection or moral hazard problems);
(3) after the point of sale, processes for identifying potential and emerging claims for the purposes of claims management and claims provisioning; this could include:

(a) identifying possible judicial rulings;
(b) keeping up to date with developments in market practice; and
(c) collecting information on industry wide initiatives and settlements.

31/12/2004

PRU 7.1.13

A firm should also identify potential pricing risks, where the liabilities or costs arising from the sale of a product may not be as expected.

31/12/2004

Risk measurement

PRU 7.1.14

A firm should have in place appropriate systems for collecting the data it needs to measure insurance risk. At a minimum this data should be capable of allowing a firm to evaluate the types of claims experienced, claims frequency and severity, expense levels, persistency levels and, where relevant, potential changes in the value of guarantees and options in long-term insurance contracts.

31/12/2004

PRU 7.1.15

A firm should ensure that the data it collects and the measurement methodologies that it uses are sufficient to enable it to evaluate, as appropriate:

(1) its exposure to insurance risk at all relevant levels, for example, by contract, policyholder, product line or insurance class;
(2) its exposure to insurance risk across different geographical areas and time horizons;
(3) its total, firm-wide, exposure to insurance risk and any other risks that may arise out of the contracts of insurance that it issues;
(4) how changes in the volume of business (for example via changes in premium levels or the number of new contracts that are underwritten) may influence its exposure to insurance risk;
(5) how changes in policy terms may influence its exposure to insurance risk; and
(6) the effects of specific loss scenarios on the insurance liabilities of the firm.

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PRU 7.1.16

A firm should hold data in a manner that allows for it to be used in a flexible way. For example, data should be sufficiently detailed and disaggregated so that contract details may be aggregated in different combinations to assess different risks.

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PRU 7.1.17

A firm should be able to justify its choice of measurement methodologies. This justification should normally be documented.

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PRU 7.1.18

A firm should periodically review the appropriateness of the measurement methodologies that it uses. This could, for example, include back testing (that is, by comparing actual versus expected results) and updating for changes in market practice.

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PRU 7.1.19

A firm should ensure that it has access to the necessary skills and resources that it needs to measure insurance risk using its chosen methodology.

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PRU 7.1.20

When measuring its insurance risks, a firm should consider how emerging experience could be used to update its underwriting process, in particular in relation to contract terms and pricing and also its assessment of the technical provisions in the balance sheet.

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PRU 7.1.21

A firm should have the capability to measure its exposure to insurance risk on a regular basis. In deciding on the frequency of measurement, a firm should consider:

(1) the time it takes to acquire and process all necessary data;
(2) the speed at which exposures could change; and
(3) that it may need to measure its exposure to certain types of insurance risk on a daily basis (for example, weather catastrophes).

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Risk monitoring

PRU 7.1.22

A firm should provide regular and timely information on its insurance risks to the appropriate level of management. This could include providing reports on the following:

(1) a statement of the firm's profits or losses for each class of business that it underwrites (with an associated analysis of how these have arisen for any long-term insurance contracts), including a variance analysis detailing any deviations from budget or changes in the key performance indicators that are used to assess the success of its business plan for insurance;
(2)the firm's exposure to insurance risk at all relevant levels (see PRU 7.1.15 G (1)), as well as across different geographical areas and time zones (see PRU 7.1.15 G (2)), also senior management should be kept informed of the firm's total exposure to insurance risk (see PRU 7.1.15 G (3));
(3) an analysis of any internal or external trends that could influence the firm's exposure to insurance risk in the future (e.g. new weather patterns, socio-demographic changes, expense overruns etc);
(4) any new or emerging developments in claims experience (e.g. changes in the type of claims, average claim amounts or the number of similar claims);
(5) the results of any stress testing or scenario analyses;
(6) the amount and details of new business written and the amount of business that has lapsed or been cancelled;
(7) identified fraudulent claims;
(8) a watch list, detailing, for example, material/catastrophic events that could give rise to significant numbers of new claims or very large claims, contested claims, client complaints, legal and other developments;
(9) the performance of any reinsurance/risk transfer arrangements; and
(10) progress reports on matters that have previously been referred under escalation procedures (see PRU 7.1.23 G).

31/12/2004

PRU 7.1.23

A firm should establish and maintain procedures for the escalation of appropriate matters to the relevant level of management. Such matters may include:

(1) any significant new exposures to insurance risk, including for example any landmark rulings in the courts;
(2) a significant increase in the size or number of claims;
(3) any breaches of the limits set out in PRU 7.1.27 G and PRU 7.1.28 G, in particular senior management should be informed where any maximum limits have been breached (see PRU 7.1.29 G); and
(4) any unauthorised deviations from its insurance risk policy (including those by a broker, appointed representative or other delegated authority).

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PRU 7.1.24

A firm should regularly monitor the effectiveness of its analysis techniques for setting provisions for claims on general insurance contracts.

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PRU 7.1.25

A firm should have appropriate procedures in place to allow managers to monitor the application (and hence the effect) of its reinsurance programme. This would include, for a general insurer, procedures for monitoring how its reinsurance programme affects the gross provisions that it makes for outstanding claims (including claims that are incurred but not reported).

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Risk control

PRU 7.1.26

A firm should take appropriate action to ensure that it is not exposed to insurance risk in excess of its risk appetite. In so doing, the firm should be both reactive, responding to actual increases in exposure, and proactive, responding to potential future increases. Being proactive should involve close co-ordination between the processes of risk control, risk identification and risk measurement, as potential future exposures need to be identified and understood before effective action can be taken to control them.

31/12/2004

PRU 7.1.27

A firm should consider setting limits for its exposure to insurance risk, which trigger action to be taken to control exposure. Periodically these limits should be amended in the light of new information (e.g. on the expected number or size of claims). For example, limits could be set for:

(1) the firm's aggregate exposure to a single source of insurance risk or for events that may be the result of a number of different sources;
(2) the firm's exposure to specific geographic areas or any other groupings of risks whose outcomes may be positively correlated;
(3) the number of fraudulent claims;
(4) the number of very large claims that could arise;
(5) the number of unauthorised deviations from its insurance risk policy;
(6) the amount of insurance risk than can be transferred to a particular reinsurer;
(7) the level of expenses incurred in respect of each relevant business area; and
(8) the level of persistency by product line or distribution channel.

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PRU 7.1.28

A firm should also consider setting individual underwriting limits for all employees and agents that have the authority to underwrite insurance risk. This could include both monetary limits and limits on the types of risk that they can underwrite. Where individual underwriting limits are set, the firm should ensure that they are adhered to.

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PRU 7.1.29

In addition to setting some 'normal' limits for insurance risk, a firm should consider setting some maximum limits, beyond which immediate, emergency action should be taken. These maximum limits could be determined through stress testing and scenario analysis.

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PRU 7.1.30

A firm should pay close attention to the wording of its policy documentation to ensure that these wordings do not expose it to more, or higher, claims than it is expecting. In so doing, the firm should consider:

(1) whether it has adequate in-house legal resources;
(2) the need for periodic independent legal review of policy documentation;
(3) the use of standardised documentation and referral procedures for variation of terms;
(4) reviewing the documentation used by other insurance companies;
(5) revising documentation for new policies in the light of past experience; and
(6) the operation of law in the jurisdiction of the policyholder.

31/12/2004

PRU 7.1.31

A firm should ensure that it has appropriate systems and controls for assessing the validity of claims. This could involve consideration of the evidence that will be required from policyholders and how this evidence is to be tested as well as procedures to determine when experts such as loss adjusters, lawyers or accountants should be used.

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PRU 7.1.32

Particular care should be taken to ensure that a firm has appropriate systems and controls to deal with large claims or large groups of claims that could significantly deplete its financial resources. This should include systems to ensure that senior management (that is, the governing body and relevant senior managers) is involved in the processing of such claims from the outset.

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PRU 7.1.33

A firm should consider how it intends to use reinsurance or some other form of insurance risk transfer agreement to help to control its exposure to insurance risk. Additional guidance on the use of reinsurance/risk transfer is provided below.

31/12/2004

Reinsurance and other forms of risk transfer

PRU 7.1.34

Before entering into or significantly changing a reinsurance agreement, or any other form of insurance risk transfer agreement, a firm should:

(1) analyse how the proposed reinsurance/risk transfer agreement will affect its exposure to insurance risk, its underwriting strategy and its ability to meet its regulatory obligations;
(2) ensure there are adequate legal checking procedures in respect of the draft agreement;
(3) conduct an appropriate due diligence of the reinsurer's financial stability (that is, solvency) and expertise; and
(4) understand the nature and limits of the agreement (particular attention should be given to the wording of contracts to ensure that all of the required risks are covered, that the level of available cover is appropriate, and that all the terms, conditions and warranties are unambiguous and understood).

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PRU 7.1.35

In managing its reinsurance agreements, or any other form of insurance risk transfer agreement, a firm should have in place appropriate systems that allow it to maintain its desired level of cover. This could involve systems for:

(1) monitoring the risks that are covered (that is, the scope of cover) by these agreements and the level of available cover;
(2) keeping underwriting staff informed of any changes in the scope or level of cover;
(3) properly co-ordinating all reinsurance/risk transfer activities so that, in aggregate, the desired level and scope of cover is maintained;
(4) ensuring that the firm does not become overly reliant on any one reinsurer or other risk transfer provider;
(5) conducting regular stress testing and scenario analysis to assess the resilience of its reinsurance and risk transfer programmes to catastrophic events that may give rise to large and or numerous claims.

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PRU 7.1.36

In making a claim on a reinsurance contract (that is, its reinsurance recoveries) or some other risk transfer contract a firm should ensure:

(1) that it is able to identify and recover any money that it is due in a timely manner; and
(2) that it makes adequate financial provision for the risk that it is unable to recover any money that it expected to be due, as a result of either a dispute with or a default by the reinsurer/risk transfer provider. Additional guidance on credit risk in reinsurance/risk transfer contracts is provided in PRU 3.2 (Credit risk in insurance).

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PRU 7.1.37

Where the planned level or scope of cover from a reinsurance/risk transfer contract is not obtained, a firm should consider revising its underwriting strategy.

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Record keeping

PRU 7.1.38

The FSA's high level rules and guidance for record keeping are outlined in SYSC 3.2.20 R (Records). Additional rules and guidance in relation to the prudential context are set out in PRU 1.4.51 G to PRU 1.4.64G. In complying with these rules and guidance, a firm should retain an appropriate record of its insurance risk management activities. This may, for example, include records of:

(1) each new risk that is underwritten (noting that these records may be held by agents or cedants, rather than directly by the firm provided that the firm has adequate access to those records);
(2) any material aggregation of exposure to risk from a single source, or of the same kind or to the same potential catastrophe or event;
(3) each notified claim including the amounts notified and paid, precautionary notices and any re-opened claims;
(4) policy and contractual documents and any relevant representations made to policyholders;
(5) other events or circumstances relevant to determining the risks and commitments that arise out of contracts of insurance (including discretionary benefits and charges under any long-term insurance contracts);
(6) the formal wordings of reinsurance contracts; and
(7) any other relevant information on the firm's reinsurance or other risk-transfer arrangements, including the extent to which they:

(a) have been exhausted by recoveries on paid claims; and
(b) will be exhausted by recoveries on reported claims and, to the extent known, on incurred but not reported claims.

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PRU 7.1.39

A firm should retain its underwriting and claims histories for as long as they may be needed to inform pricing or provisioning decisions.

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PRU 7.2

Capital resources requirements and technical provisions for insurance business

01/10/2005

Application

PRU 7.2.1

PRU 7.2 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 7.2.2

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

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PRU 7.2.3

For a non-EEA direct insurer with a branch in the United Kingdom, the part of this section headed "Capital requirements for insurers" (PRU 7.2.43 G to PRU 7.2.91 R) applies to its world-wide activities, whilst the parts of this section headed "Establishing technical provisions" (PRU 7.2.12 R to PRU 7.2.19 G), "Assets of a value sufficient to cover technical provisions and other liabilities" (PRU 7.2.20 R to PRU 7.2.29 G), "Matching of assets and liabilities" (PRU 7.2.34 R to PRU 7.2.40 G) and "Premiums for new business" (PRU 7.2.41 R to PRU 7.2.42 G) apply in respect of its activities carried on from a branch in the United Kingdom. The part of this section headed "Localisation" (PRU 7.2.30 R to PRU 7.2.33 R) does not apply (see PRU 7.6 (Internal contagion risk)).

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PRU 7.2.4

For an EEA-deposit insurer or a Swiss general insurer, the parts of this section headed "Establishing technical provisions" (PRU 7.2.12 R to PRU 7.2.19 G), "Assets of a value sufficient to cover technical provisions and other liabilities" (PRU 7.2.20 R to PRU 7.2.29 G), "Matching of assets and liabilities" (PRU 7.2.34 R to PRU 7.2.40 G) and "Premiums for new business" (PRU 7.2.41 R to PRU 7.2.42 G) apply in respect of the activities of the firm carried on from a branch in the United Kingdom. The parts of this section headed "Capital requirements for insurers" (PRU 7.2.43 G to PRU 7.2.91 R) and "Localisation" (PRU 7.2.30 R to PRU 7.2.33 R) do not apply.

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PRU 7.2.5

For a UK-deposit insurer, the part of this section headed "Capital requirements for insurers" (PRU 7.2.43 G to PRU 7.2.91 R) applies to its world-wide activities, whilst the parts of this section headed "Establishing technical provisions" (PRU 7.2.12 R to PRU 7.2.19 G), "Assets of a value sufficient to cover technical provisions and other liabilities" (PRU 7.2.20 R to PRU 7.2.29 G), "Matching of assets and liabilities" (PRU 7.2.34 R to PRU 7.2.40 G) and "Premiums for new business" (PRU 7.2.41 R to PRU 7.2.42 G) apply in respect of the activities of the firm carried on from branches in EEA States. The part of this section headed "Localisation" (PRU 7.2.30 R to PRU 7.2.33 R) does not apply (see PRU 7.6 (Internal contagion risk)).

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PRU 7.2.6

This section may apply in cases where a firm has its head office in another EEA State but is neither an incoming EEA firm nor an incoming Treaty firm; this could arise in the case of a non-directive mutual or a pure reinsurer.

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Purpose

PRU 7.2.7

PRU 7.2 has the aim of reducing the risk that a firm may fail to meet its liabilities to its policyholders as a result of insurance risk, that is, the risk that arises from the inherent uncertainties as to the occurrence, amount and timing of insurance liabilities.

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PRU 7.2.8

This section requires that the technical provisions that firms establish are adequate to meet their liabilities to policyholders under contracts of insurance. It also requires that firms hold assets of a value sufficient to cover their liabilities, including technical provisions, and that there is suitable matching of assets and liabilities. Technical provisions are the on-balance sheet provisions made by a firm in respect of liabilities arising under or in connection with contracts of insurance. There are different rules and guidance applicable to the calculation of technical provisions for general insurance business and for long-term insurance business.

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PRU 7.2.9

This section implements requirements of the Insurance Directives for both general insurance business and long-term insurance business with regard to the technical provisions. The relevant articles of the Directives include:

(1) article 15 of the First Non-Life Directive, as substituted by article 17 of the Third Non-Life Directive; and
(2) article 20 of the Consolidated Life Directive (this Directive consolidates the provisions of the previous First, Second and Third Life Directives).

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PRU 7.2.10

This section also sets out detailed rules and guidance on the calculation of the following elements of a firm's capital resources requirement (CRR) (see PRU 2.1):

(1) the general insurance capital requirement; and
(2) the long-term insurance capital requirement.

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PRU 7.2.11

These requirements are dealt with in the part of this section headed "Capital requirements for insurers" (see PRU 7.2.43 G to PRU 7.2.91 R). That part of this section also contains rules about the calculation of the insurance-related capital requirement, which forms part of the enhanced capital requirement for firms carrying on general insurance business. The asset-related capital requirement for firms carrying on general insurance business is set out in PRU 3.3.

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Establishing technical provisions

PRU 7.2.12

For general insurance business, a firm must establish adequate technical provisions:

(1) in accordance with the rules in PRU 7.5 for equalisation provisions; and
(2) otherwise, in accordance with PRU 1.3.5R.

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PRU 7.2.13

For general insurance business, the technical provisions include outstanding claims provisions, unearned premiums provisions, unexpired risk provisions and equalisation provisions. These provisions take into account the expected ultimate cost of claims, including those not yet incurred, related expenses and include an allowance for smoothing claims (the equalisation provision).

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PRU 7.2.14

Discounting (that is discounting for the time value of money) general insurance business technical provisions may be carried out only in limited circumstances and on a prudent basis (see PRU 2.2.80R and PRU 2.2.81R and paragraph 48 of the insurance accounts rules). The fact that the expected liabilities are generally not discounted helps to protect against risk from inherent uncertainty in the timing, but not necessarily the amount, of claims.

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PRU 7.2.15

For some categories of general insurance business, equalisation provisions are required. These ensure that a firm retains additional assets to provide some extra protection against uncertainty as to the amount of claims. Equalisation provisions are particularly suitable for volatile business, where claims in any future year may be subject to significant adverse deviation from recent or average expected claims experience, or where trends in claims experience may be subject to change. Such volatile claims experience arises in a number of types of business, for example, property, marine and aviation, nuclear, certain non-proportional reinsurance treaty business, and credit insurance. The equalisation provisions help to equalise fluctuations in loss ratios in future years (see PRU 7.5 (Equalisation provisions)).

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PRU 7.2.16

For long-term insurance business, a firm must establish adequate technical provisions in respect of its long-term insurance contracts as follows:

(1) mathematical reserves in accordance with the rules and guidance in PRU 7.3 relating to such reserves, and with due regard to generally accepted actuarial practice; and
(2) for liabilities in respect of such contracts that have fallen due, in accordance with PRU 1.3.5R.

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PRU 7.2.17

Rules and guidance for calculating mathematical reserves are set out in PRU 7.3. Firms are advised by the actuarial function (see SUP 4) on the methods and assumptions to be used in calculating the mathematical reserves. The standards and guidance issued by the Faculty and Institute of Actuaries to assist actuaries appointed to the actuarial function are important sources of evidence as to generally accepted actuarial practice, as referred to in PRU 7.2.16 R (1).

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PRU 7.2.18

For long-term insurance business, the technical provisions include the mathematical reserves. These are actuarial estimates of a firm's liabilities in respect of future benefits due to policyholders, including bonuses already declared. The mathematical reserves may be reduced by the actuarial value of that component of future premiums attributable to meeting future liabilities (see PRU 7.3 (Mathematical reserves)).

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PRU 7.2.19

For long-term insurance business, the mathematical reserves are typically valued on a discounted basis but include valuation margins intended to provide protection against adverse deviations in experience (see PRU 7.3).

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Assets of a value sufficient to cover technical provisions and other liabilities

PRU 7.2.20

A firm which is not a composite firm must hold admissible assets of a value at least equal to the amount of:

(1) the technical provisions that it is required to establish under PRU 7.2.12 R or PRU 7.2.16 R; and
(2) its other general insurance liabilities or long-term insurance liabilities;

but excluding property-linked liabilities and index-linked liabilities and the assets held to cover them under PRU 4.2.57 R and PRU 4.2.58 R.

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PRU 7.2.21

A composite firm must ensure that:

(1) it holds admissible assets separately identified in accordance with PRU 7.6.18 R of a value at least equal to the amount of:

(a) the technical provisions that it is required to establish under PRU 7.2.16 R; and
(b) its other long-term insurance liabilities;

but excluding property-linked liabilities and index-linked liabilities and the assets held to cover them under PRU 4.2.57 R and PRU 4.2.58 R; and
(2) it holds other admissible assets (other than those excluded under (1)) of a value at least equal to the amount of:

(a) the technical provisions that it is required to establish under PRU 7.2.12 R; and
(b) its other general insurance liabilities.

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PRU 7.2.22

PRU 7.6 (Internal-contagion risk) sets out the rules and guidance on identifying and holding in a separate fund long-term insurance assets.

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PRU 7.2.23

When valuing assets for the purposes of PRU 7.2.20 R and PRU 7.2.21 R, a firm should bear in mind:

(1) that the technical provisions and other long-term insurance liabilities or general insurance liabilities should be covered by admissible assets (see PRU 2 Annex 1 RR); and
(2) the market and counterparty limits set out in PRU 3.2 (Credit risk in insurance). PRU 3.2 requires that a firm restrict to prudent levels its exposure to reinsurer and other counterparties, and, in particular, that for the purpose of its balance sheet, a firm must not take into account any exposure which exceeds the large exposure limits.

31/12/2005

PRU 7.2.24

Rules and guidance on the valuation of assets are set out in PRU 1.3 (Valuation), including the treatment of shares in, and debts due from, related undertakings in PRU 1.3.31R to PRU 1.3.42 G. PRU 4.2 (Market risk in insurance) addresses market risk and sets out the matching requirements for linked assets and liabilities. PRU 4.2 also sets out rules and guidance on the matching by currency of assets and liabilities, to reduce a firm's exposure to currency market risk.

31/12/2004

PRU 7.2.25

For the purpose of determining the value of assets available to meet technical provisions and other long-term insurance liabilities in accordance with PRU 7.2.20 R, PRU 7.2.21 R, PRU 7.2.27 R and PRU 7.2.28 R, no value is to be attributed to:

(1) debts owed by reinsurers; or
(2) claims; or
(3) tax recoveries; or
(4) claims against compensation funds;

to the extent already offset in the calculation of technical provisions.

31/12/2005

PRU 7.2.26

Certain debts and claims are excluded from PRU 7.2.20 R, PRU 7.2.21 R, PRU 7.2.27 R and PRU 7.2.28 R to avoid double-counting. The rules and guidance in PRU 7.3 (Mathematical reserves) set out how a firm may offset debts and claims against liabilities in calculating the mathematical reserves required for long-term insurance business.

31/12/2005

PRU 7.2.27

A firm carrying on long-term insurance business must ensure that it has admissible assets in each of its with-profits funds of a value sufficient to cover:

(1) the technical provisions in respect of all the business written in that with-profits fund; and
(2) its other long-term insurance liabilities in respect of that with-profits fund.

31/12/2005

PRU 7.2.28

In addition to complying with PRU 7.2.27 R, a realistic basis life firm must also ensure that the realistic value of assets for each of its with-profits funds is at least equal to the realistic value of liabilities of that fund.

31/12/2004

PRU 7.2.29

PRU 7.2.27 R and PRU 7.2.28 R support the funding of policyholder benefits by requiring firms to maintain admissible assets in with-profits funds to cover the technical provisions and other long-term insurance liabilities relating to all the business in that fund and, in the case of a realistic basis life firm, realistic assets to cover the realistic liabilities of the with-profits insurance contracts written in the fund.

31/12/2005

Localisation (UK firms only)

PRU 7.2.30

(1) Subject to (2), a UK firm must hold admissible assets held pursuant to PRU 4.2.53R:

(a) (where the admissible assets cover technical provisions in pounds sterling), in any EEA State; and
(b) (where the admissible assets cover technical provisions in any currency other than pounds sterling), in any EEA State or in the country of that currency.

(2) In the case of a community co-insurance operation and a relevant insurer, the admissible assets covering technical provisions must be held in any EEA State.

31/12/2004

PRU 7.2.31

PRU 7.6 (Internal contagion risk) sets out the rules and guidance on localisation for firms other than UK firms.

31/12/2004

PRU 7.2.32

PRU 7.2.30 R does not apply to:

(1) a pure reinsurer; or
(2) debts owed by reinsurers; or
(3) insurance business carried on by a UK firm outside the EEA States; or
(4) general insurance business class groups 3 and 4 in IPRU(Ins), Annex 11.2, Part II.

31/12/2004

PRU 7.2.33

For the purposes of PRU 7.2.30 R:

(1) a tangible asset is to be treated as held in the country or territory where it is situated;
(2) an admissible asset consisting of a claim against a debtor is to be treated as held in any country or territory where it can be enforced by legal action;
(3) a listed security is to be treated as held in any country or territory where there is a regulated market on which the security is dealt; and
(4) a security which is not a listed security is to be treated as held in the country or territory in which the issuer has its head office.

31/12/2004

Matching of assets and liabilities

PRU 7.2.34

(1) Subject to (4), the assets held by a firm to cover its technical provisions and other long-term insurance liabilities or general insurance liabilities (see PRU 7.2.20 R and PRU 7.2.21 R) must:

(a) have characteristics of safety, yield and marketability which are appropriate to the type of business carried on by the firm;
(b) be diversified and adequately spread; and
(c) comply with (2).

(2) The assets referred to in (1) must, in addition to meeting the criteria set out in (1)(a) and (b), be of a sufficient amount, and of an appropriate currency and term, to ensure that the cash inflows from those assets will meet the expected cash outflows from the firm's insurance liabilities as they become due.
(3) For the purpose of (2), a firm must take into consideration in determining expected cash outflows any options which exist in the firm's contracts of insurance.
(4) (1) does not apply to assets held to cover index-linked liabilities or property-linked liabilities, except that where the linked long-term contract of insurance in question includes a guarantee of investment performance or some other guaranteed benefit, (1) will nevertheless apply to assets held to cover that guaranteed element.

31/12/2005

PRU 7.2.35

A firm should take account of the amount, currency and timing of its expected cash outflows in determining whether the assets it holds to cover its technical provisions and other long-term insurance liabilities or general insurance liabilities meet the requirements of PRU 7.2.34 R (2).

31/12/2005

PRU 7.2.36

For the purpose of PRU 7.2.34 R (2), the relevant cash inflows are those which the firm reasonably expects to receive from the admissible assets which it holds to cover its technical provisions and other long-term insurance liabilities or general insurance liabilities. A firm may receive cash inflows as a result of:

(1) selling assets or closing out transactions;
(2) holding assets that generate dividends, interest or other income; and
(3) receiving future premiums for existing business.

31/12/2005

PRU 7.2.37

Anticipated cash inflows from future new business should not be included, for example where the customer has not yet contracted to pay the premium, and where the associated liabilities and potential cash outflows should also not be included.

31/12/2004

PRU 7.2.38

A firm should compare cash inflows and outflows based on current expectations of amounts and timings. Current market expectations of future asset values, interest rates and currency exchange rates should be used. Where inflows are received in a currency different from that in which outflows are to be paid, account should be taken of the cost of converting the currency received.

31/12/2004

PRU 7.2.39

In considering the value and suitability of assets required to ensure that the firm's liabilities are met as they become due, a firm should take account of the risk of default on inflows from those assets, and other risks that may mean that future inflows are reduced relative to outflows.

31/12/2004

PRU 7.2.40

PRU 7.2.20 R lays down a general requirement for a firm that carries on long-term insurance business to hold admissible assets that are of a value sufficient to cover its technical provisions and other long-term insurance liabilities. The PRU 7.2.34 R (2) requirement to match liabilities with assets that allow cash outflows to be met with suitable inflows as the outflows become due may mean that a firm has to hold assets of a value greater than would otherwise be required by the general rule in PRU 7.2.20 R.

31/12/2005

Premiums for new business

PRU 7.2.41

A firm must not enter into a long-term insurance contract unless it is satisfied on reasonable actuarial assumptions that:

(1) the premiums receivable and the investment income expected to be earned from those premiums; and
(2) the reinsurance arrangements made in respect of the risk or risks covered by that new contract;
are sufficient to enable it, when taken together with the firm's other resources, to:

(a) establish adequate technical provisions as required by PRU 7.2.16 R;
(b) hold admissible assets of a value at least equal to the amount of the technical provisions and other long-term insurance liabilities as required by PRU 7.2.20 R to PRU 7.2.28 R; and
(c) maintain adequate overall financial resources as required by PRU 1.2.22R.

31/12/2005

PRU 7.2.42

For the purposes of PRU 7.2.41 R, the adequacy of premiums may be assessed in the context of a firm's total portfolio of business and its other resources. It thus does not prevent a firm writing loss leaders nor writing contracts which might incur large losses, but only if the firm can meet the losses that might reasonably arise, including those that would arise from an event specifically insured against.

31/12/2004

Capital requirements for insurers

PRU 7.2.43

(1) PRU 2.1.9R requires a firm to maintain capital resources equal to or in excess of its capital resources requirement (CRR). PRU 2.1 sets out the overall framework of the CRR; in particular, PRU 2.1.14 R requires that for a firm carrying on general insurance business the CRR is equal to the minimum capital requirement (MCR). PRU 2.1.15 R requires that for realistic basis life firms the CRR is the higher of the MCR and the ECR. PRU 2.1.20 R requires that for regulatory basis only life firms the CRR is equal to the MCR.
(2) For non-life firms the MCR represents the minimum capital requirement (or margin of solvency) prescribed by the Insurance Directives. PRU 2.1.21 R provides that, for a firm carrying on general insurance business, the MCR in respect of that business is the higher of the base capital resources requirement for general insurance business applicable to that firm and the general insurance capital requirement. PRU 2.1.22 R provides that, for a firm carrying on long-term insurance business, the MCR in respect of that business is the higher of the base capital resources requirement for long-term insurance business applicable to that firm and the sum of the long-term insurance capital requirement and the resilience capital requirement. As specified in PRU 2.1.10 R, a firm carrying on both general insurance business and long-term insurance business must apply PRU 2.1.9R (referred to in paragraph (1) above) separately to its general insurance business and its long-term insurance business.
(3) The calculation of the general insurance capital requirement is set out in PRU 7.2.44 G to PRU 7.2.72 R below. PRU 7.2.73 G to PRU 7.2.79 R set out the calculation of the insurance-related capital requirement for non-life firms. The calculation of the long-term insurance capital requirement is set out in PRU 7.2.80 G to PRU 7.2.91 R below.

31/12/2004

General insurance capital requirement

PRU 7.2.44

In relation to the MCR (see PRU 7.2.43 G), PRU 2.1.30 R requires a firm to calculate its general insurance capital requirement (GICR) as the highest of the premiums amount, the claims amount, and the brought forward amount. The elements for this computation are set out in PRU 7.2 as follows:

(1) the premiums amount in PRU 7.2.45 R;
(2) the claims amount in PRU 7.2.47 R; and
(3) the brought forward amount in PRU 7.2.51 R.

31/12/2004

The premiums amount

PRU 7.2.45

The premiums amount is:

(1) 18% of the gross adjusted premiums amount; less 2% of the amount, if any, by which the gross adjusted premiums amount exceeds €50 million; multiplied by
(2) the reinsurance ratio set out in PRU 7.2.54 R.

31/12/2004

PRU 7.2.46

Rules and guidance as to how the gross adjusted premiums amount is to be calculated are set out in PRU 7.2.56 R to PRU 7.2.59 G.

31/12/2004

The claims amount

PRU 7.2.47

The claims amount is:

(1) 26% of the gross adjusted claims amount; less 3% of the amount, if any, by which the gross adjusted claims amount exceeds € 35 million; multiplied by
(2) the reinsurance ratio set out in PRU 7.2.54 R.

31/12/2004

PRU 7.2.48

Rules and guidance as to how the gross adjusted claims amount is to be calculated are set out in PRU 7.2.60 R to PRU 7.2.65 G.

31/12/2004

PRU 7.2.49

(1) Subject to (2) and (3), the Euro amounts specified in PRU 7.2.45 R (1) and PRU 7.2.47 R (1) will increase each year, starting on the first review date of 20 September 2005 (and annually after that), by the percentage change in the European index of consumer prices (comprising all European Union member states, as published by Eurostat) from 20 March 2002 to the relevant review date, rounded up to a multiple of €100,000.
(2) In any year, if the percentage change since the last increase is less than 5%, then there will be no increase.
(3) The increase will take effect 30 days after the EU Commission has informed the European Parliament and Council of its review and the relevant percentage change.

31/12/2004

PRU 7.2.50

For the purposes of PRU 7.2.45 R (1) and PRU 7.2.47 R (1), 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.

31/12/2004

The brought forward amount

PRU 7.2.51

The brought forward amount is the general insurance capital requirement (GICR) for the prior financial year, multiplied, if the ratio is less than one, by the ratio (expressed as a percentage) of:

(1) the technical provisions (calculated net of reinsurance) for claims outstanding at the end of the prior financial year, determined in accordance with PRU 7.2.12 R; to
(2) the technical provisions (calculated net of reinsurance) for claims outstanding at the beginning of the prior financial year, determined in accordance with PRU 7.2.12 R.

31/12/2004

PRU 7.2.52

The brought forward amount is the same as the GICR for the prior financial year, except where claims outstanding have fallen during that financial year. If they have fallen, the brought forward amount is itself reduced by the same percentage fall.

31/12/2004

PRU 7.2.53

If the GICR for the prior financial year is less than the premiums amount or the claims amount, then a brought forward amount is not required to be calculated.

31/12/2004

Reinsurance ratio used in calculating the premiums amount and the claims amount

PRU 7.2.54

The reinsurance ratio referred to in PRU 7.2.45 R (2) and PRU 7.2.47 R (2) is:

(1) if the ratio lies between 50% and 100%, the ratio (expressed as a percentage) of:

(a) the claims incurred (net of reinsurance) in the financial year in question and the two previous financial years; to
(b) the gross claims incurred in that three-year period;

(2) 50%, if the ratio calculated in (a) and (b) of (1) is 50% or less; and
(3) 100%, if the ratio calculated in (a) and (b) of (1) is 100% or more.

31/12/2004

PRU 7.2.55

Rules and guidance as to how the net and gross claims are to be calculated are set out in PRU 7.2.66 R to PRU 7.2.71 R.

31/12/2004

Gross adjusted premiums amount used in calculating the premiums amount

PRU 7.2.56

For the purpose of PRU 7.2.45 R, the gross adjusted premiums amount is the higher of the written and earned gross premiums (as adjusted in accordance with PRU 7.2.66 R) for the financial year in question, adjusted by:

(1) except for a pure reinsurer that does not have permission under the Act to effect contracts of insurance, increasing by 50% the amount included in respect of the premiums for general insurance business classes 11, 12 and 13;
(2) deducting 66.7% of the premiums for actuarial health insurance that meets the conditions set out in PRU 7.2.72 R; and
(3) multiplying the resulting figure by 12 and dividing by the number of months in the financial year. For the purposes of this calculation, the number of months in the financial year is the number of complete calendar months in the financial year plus any fractions of a month at the beginning and the end of the financial year.

31/12/2005

PRU 7.2.57

A firm may use statistical methods in order to allocate premiums in respect of the classes 11, 12 and 13 for the purposes of PRU 7.2.56 R.

31/12/2004

PRU 7.2.58

General insurance business classes 11, 12 and 13 are, respectively, the marine liability, aviation liability and general liability insurance classes.

31/12/2004

PRU 7.2.59

Where the firm did not carry on insurance business in the financial year in question, the gross adjusted premiums amount, and therefore the premiums amount, is nil.

31/12/2004

Gross adjusted claims amount used in calculating the claims amount

PRU 7.2.60

For the purpose of PRU 7.2.47 R and subject to PRU 7.2.62 R, the gross adjusted claims amount is the amount of gross claims incurred (as determined in accordance with PRU 7.2.66 R) over the reference period (as specified in PRU 7.2.63 R) and adjusted by:

(1) except for a pure reinsurer that does not have permission under the Act to effect contracts of insurance, increasing by 50% the amount included in respect of the claims incurred for general insurance business classes 11, 12 and 13;
(2) deducting 66.7% of the claims for actuarial health insurance that meets the conditions set out in PRU 7.2.72 R; and
(3) multiplying the resulting figure by 12 and dividing by the number of months in the reference period. For the purposes of this calculation, the number of months in the reference period is the number of complete calendar months in the reference period plus any fractions of a month at the beginning and the end of the reference period.

31/12/2004

PRU 7.2.61

A firm may use statistical methods in order to allocate claims in respect of classes 11, 12 and 13 for the purposes of PRU 7.2.60 R.

31/12/2004

PRU 7.2.62

For the purposes of PRU 7.2.47 R, in relation to general insurance business class 18, the amount of claims incurred used to calculate the gross adjusted claims amount must be the amount of costs recorded in the firm's books in the reference period as borne by the firm (whether or not borne in the reference period) in respect of the assistance given.

31/12/2004

PRU 7.2.63

(1) Except in those cases where paragraph (2) applies, the reference period to be used in PRU 7.2.60 R and PRU 7.2.62 R must be:

(a) the financial year in question and the two previous financial years; or
(b) the period the firm had been in existence at the end of the financial year in question, if shorter.

(2) In the case of a firm which underwrites only one or more of the general insurance business risks of credit, storm, hail or frost (including other business written in connection with such risks), the reference period to be used must be:

(a) the financial year in question and the six previous financial years; or
(b) the period the firm had been in existence at the end of the financial year in question, if shorter.

31/12/2004

PRU 7.2.64

The classification of the risks referred to in PRU 7.2.63 R (2) is as follows: credit - as included in general insurance business class 14; storm - as included in general insurance business class 8; hail - as included in general insurance business class 9; and frost - as included in general insurance business class 9.

31/12/2004

PRU 7.2.65

Where the firm did not carry on insurance business in the reference period, the gross adjusted claims amount, and therefore the claims amount, is nil.

31/12/2004

Accounting for premiums and claims

PRU 7.2.66

For the purposes of PRU 7.2.54 R, PRU 7.2.56 R, PRU 7.2.60 R and PRU 7.2.62 R, amounts of premiums and claims must be:

(1) determined in accordance with the insurance accounts rules or the Friendly Societies (Accounts and Related Provisions) Regulations 1994, as appropriate; and
(2) adjusted for transfers that were approved by the relevant authority (or became effective where approval by an authority was not required) before the end of the financial year in question:

(a) to exclude any amount included in, or adjustment made to, premiums and claims to reflect the consideration for a transfer of contracts of insurance to or from the firm;
(b) to exclude premiums and claims which arose from contracts of insurance that have been transferred by the firm to another body; and
(c) to account for premiums and claims which arose from contracts of insurance that have been transferred to the firm from another body as if they were receivable by or payable to the firm.

31/12/2005

PRU 7.2.67

To ensure that all rights and obligations under a contract of insurance are transferred, a number of alternative mechanisms could be used. These are: an insurance business transfer under Part VII of the Act; under earlier United Kingdom insurance legislation; under equivalent foreign legislation; or by novation of contracts. The term "relevant authority" in paragraph (2) of PRU 7.2.66 R may refer to whatever body has responsibility in a country, whether within or outside the EEA, for the approval of transfers of portfolios of contracts of insurance; the body may be a supervisory authority for financial services as such or it may be a judicial authority which has the necessary responsibility.

31/12/2004

PRU 7.2.68

PRU 7.2.66 R (2)(b) requires a firm, for the purpose of calculating its GICR, to account for contracts of insurance transferred by it to another body as if it had never written those contracts. All amounts of premiums and claims arising in respect of those contracts are excluded, including amounts that arose in the financial year in question or previous financial years.

31/12/2004

PRU 7.2.69

Conversely, PRU 7.2.66 R (2)(c) requires a firm, for the purpose of calculating its GICR, to account for contracts of insurance transferred to it by another body as if it had been responsible for those contracts from inception and not merely from the date of transfer. All amounts of premiums and claims that arose from those contracts are included even where they arose prior to the date of transfer and were, in fact, receivable by or payable to the other body.

31/12/2004

PRU 7.2.70

For both transfers to and from the firm, the consideration receivable or payable in respect of the transfer is excluded from premiums and claims in order to avoid double counting.

31/12/2004

PRU 7.2.71

Where there has been a significant change in the business portfolio of the firm since the end of the financial year in question, for example, a line of business has been transferred to another firm, or the firm no longer carries on a particular class of insurance business, the gross adjusted premiums amount and the gross adjusted claims amount must both be recalculated to take into account the impact of this change. The recalculation must take into account the requirements of the insurance accounts rules or the Friendly Societies (Accounts and Related Provisions) Regulations 1994, as appropriate.

31/12/2005

Actuarial health insurance

PRU 7.2.72

The conditions referred to in PRU 7.2.56 R (2) and PRU 7.2.60 R (2) are that:

(1) the health insurance is underwritten on a similar technical basis to that of life insurance;
(2) the premiums paid are calculated on the basis of sickness tables according to the mathematical method applied in insurance;
(3) a provision is set up for increasing age;
(4) an additional premium is collected in order to set up a safety margin of an appropriate amount;
(5) it is not possible for the firm to cancel the contract after the end of the third year of insurance; and
(6) the contract provides for the possibility of increasing premiums or reducing payments even for current contracts.

31/12/2004

Insurance-related capital requirement (general insurance business only)

PRU 7.2.73

PRU 2.3.11 R requires firms carrying on general insurance business, other than a non-directive insurer, to calculate their ECR as the sum of the asset-related capital requirement and the insurance-related capital requirement less the firm's equalisation provisions. 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 firms carrying on general insurance business, the FSA will use the ECR as a benchmark for individual capital guidance for a firm carrying on general insurance business. Details of the calculation of the asset-related capital requirement are set out in PRU 3.3. Details of the calculation of the insurance-related capital requirement are set out in PRU 7.2.76 R to PRU 7.2.79 R.

31/12/2004

PRU 7.2.74

The insurance-related capital requirement is a measure of the capital that a firm should hold against the risk of:

(1) an adverse movement in the value of a firm's liabilities, to recognise that there may be substantial volatility in claims and other technical provisions made by the firm. Such variations may be due to inflationary increases, interest rate changes, movements in the underlying provisions themselves, changes in expense costs, inadequate rate pricing or premium collections (or both) from intermediaries differing from projected assumptions; and
(2) the premiums a firm charges in respect of particular business not being adequate to fund future liabilities arising from that business.

31/12/2004

PRU 7.2.75

The insurance-related capital requirement is calculated by applying capital charge factors, expressed as a percentage, to the value of the net written premiums and the technical provisions in respect of different classes of business. Firms should refer to PRU 1.3.5 R which sets out how a firm must recognise and value assets and liabilities.

31/12/2004

Calculation of the insurance-related capital requirement

PRU 7.2.76

A firm must calculate its insurance-related capital requirement in accordance with PRU 7.2.77 R.

31/12/2004

PRU 7.2.77

(1) The value of:

(a) the net written premiums; and
(b) the technical provisions;

in respect of each class of business listed in the table in PRU 7.2.79 R must be multiplied by the corresponding capital charge factor.
(2) If any amount which is to be multiplied by a capital charge factor is a negative amount, that amount shall be treated as zero.
(3) The amounts resulting from multiplying the net written premiums in respect of each such class of business by the corresponding capital charge factor must be aggregated.
(4) The amounts resulting from multiplying the technical provisions in respect of each such class of business by the corresponding capital charge factor must be aggregated.
(5) The insurance-related capital requirement is the sum of the amounts calculated in accordance with (3) and (4).

31/12/2004

PRU 7.2.78

In PRU 7.2.77 R references to technical provisions comprise:

(1) outstanding claims;
(2) provisions for incurred but not reported (IBNR) claims;
(3) provisions for incurred but not enough reported (IBNER) claims;
(4) unearned premium reserves less deferred acquisition costs; and
(5) unexpired risk reserves;

in each case net of reinsurance receivables.

31/12/2004

PRU 7.2.79

Table: Insurance-related Capital Charge Factors

Class of Business

Net Written Premium capital charge factor

Technical provision capital charge factor

Reporting Group: Direct and facultative business

Direct and facultative accident and health

5.0%

7.5%

Direct and facultative personal lines motor business

10.0%

9.0%

Direct and facultative household and domestic all risks

10.0%

Direct and facultative personal lines financial loss

25.0%

14.0%

Direct and facultative commercial motor business

10.0%

9.0%

Direct and facultative commercial lines property

10.0%

Direct and facultative commercial lines liability

14.0%

Direct and facultative commercial lines financial loss

25.0%

14.0%

Direct and facultative aviation

32.0%

14.0%

Direct and facultative marine

22.0%

17.0%

Direct and facultative goods in transit

12.0%

14.0%

Direct and facultative miscellaneous

25.0%

14.0%

Reporting Group: Non-Proportional Treaty

Non-proportional accident & health

35.0%

16.0%

Non-proportional motor

10.0%

14.0%

Non-proportional transport

16.0%

15.0%

Non-proportional aviation

61.0%

16.0%

Non-proportional marine

38.0%

17.0%

Non-proportional property

53.0%

12.0%

Non-proportional liability (non-motor)

14.0%

Non-proportional financial lines

39.0%

14.0%

Non-proportional aggregate cover

53.0%

12.0%

Reporting Group: Proportional Treaty

Proportional accident & health

12.0%

16.0%

Proportional motor

10.0%

12.0%

Proportional transport

12.0%

15.0%

Proportional aviation

33.0%

16.0%

Proportional marine

22.0%

17.0%

Proportional property

23.0%

12.0%

Proportional liability (non-motor)

14.0%

Proportional financial lines

25.0%

14.0%

Proportional aggregate cover

23.0%

12.0%

Reporting Group: Miscellaneous Reinsurance

Miscellaneous reinsurance accepted business

39.0%

14.0%

31/12/2005

Long-term insurance capital requirement

PRU 7.2.80

PRU 2.1.9 R requires a firm to which PRU 2 applies to maintain capital resources equal to or in excess of its capital resources requirement. PRU 2.1.15 R defines the capital resources requirement for a firm to which that rule applies (a realistic basis life firm) as the higher of the MCR and the ECR. For other firms carrying on long-term insurance business (regulatory basis only life firms), the capital resources requirement is equal to the MCR. The MCR is defined as the higher of the base capital resources requirement and the sum of the long-term insurance capital requirement (LTICR) and the resilience capital requirement (see PRU 2.1.22 R). PRU 2.1.32 R defines the LTICR as the sum of the insurance death, health, expense, and market risk capital components (see PRU 7.2.81 R to PRU 7.2.91 R). Rules and guidance about the resilience capital requirement are set out in PRU 4.2.9 G to PRU 4.2.26 R.

31/12/2004

Insurance death risk capital component

PRU 7.2.81

The insurance death risk capital component is the aggregate of the amounts which represent the fractions specified by PRU 7.2.82 R of the capital at risk, defined in PRU 7.2.83 R, for each category of contracts of insurance (as specified in PRU 7.2.81A R), in respect of those contracts where the capital at risk is not a negative figure, multiplied by the higher of:

(1) 50%; and
(2) the ratio as at the end of the financial year in question of:

(a) the aggregate capital at risk in respect of that category of contracts net of reinsurance cessions; to
(b) the aggregate capital at risk in respect of that category of contracts gross of reinsurance cessions.

31/12/2005

PRU 7.2.81A

For the purpose of PRU 7.2.81 R, the categories of contracts of insurance are as follows:

(1) contracts which fall in long-term insurance business classes I, II or IX; and
(2) contracts which fall in long-term insurance business classes III, VII or VIII.

31/12/2005

PRU 7.2.82

For the purpose of PRU 7.2.81 R, the fraction is:

(1) for long-term insurance business classes I, II and IX, except for a pure reinsurer:

(a) 0.1% for temporary insurance on death where the original term of the contract is three years or less;
(b) 0.15% for temporary insurance on death where the original term of the contract is five years or less but more than three years; and
(c) 0.3% in any other case;

(2) 0.3% for long-term insurance business classes III, VII and VIII, except for a pure reinsurer; and
(3) 0.1% for a pure reinsurer.

31/12/2004

PRU 7.2.83

For the purpose of PRU 7.2.81 R, the capital at risk is:

(1) where the benefit under a contract of insurance payable as a result of death includes periodic or deferred payments, the present value of the benefits payable; and
(2) in any other case, the amount payable as a result of death;

less, in either case, the mathematical reserves for the contract.

31/12/2004

PRU 7.2.84

The insurance death risk capital component only relates to the risk of death. There is a separate risk component for insured health risks (class IV). Tontines (class V) and capital redemption operations (class VI) also have separate risk components. There is no specified risk margin for other insured risks.

31/12/2004

Insurance health risk capital component

PRU 7.2.85

The insurance health risk capital component is the highest of:

(1) the premiums amount (determined in accordance with PRU 7.2.45 R);
(2) the claims amount (determined in accordance with PRU 7.2.47 R); and
(3) the brought forward amount (determined in accordance with PRU 7.2.51 R);
in respect of:

(a) contracts of insurance falling in long-term insurance business class IV (see PRU 7.2.86 R); and
(b) risks falling in general insurance business classes 1 or 2 that are written as part of a long-term insurance contract.

31/12/2004

PRU 7.2.86

For the purposes of PRU 7.2.85 R, in the case of contracts of insurance falling in long-term insurance business class IV, condition (3) as set out in PRU 7.2.72 R (Actuarial health insurance) is modified to: "either the reserves include a provision for increasing age, or the business is conducted on a group basis.".

31/12/2004

PRU 7.2.87

The insurance health risk capital component only arises for permanent health insurance (long-term insurance business class IV) and accident and sickness insurance (general insurance business classes 1 and 2).

31/12/2004

Insurance expense risk capital component

PRU 7.2.88

The insurance expense risk capital component is:

(1) in respect of long-term insurance business classes III, VII and VIII, an amount equivalent to 25% of the net administrative expenses in the financial year in question relevant to the business of each of those classes, in so far as the firm bears no investment risk and the allocation to cover management expenses in the contract of insurance does not have a fixed upper limit which is effective as a limit for a period exceeding 5 years from the commencement of the contract;
(2) in respect of any tontine (long-term insurance business class V), 1% of the assets of the tontine;
(3) in the case of any other long-term insurance business, 1% of the "adjusted mathematical reserves" (as defined in PRU 7.2.89A R).

31/12/2005

Insurance market risk capital component

PRU 7.2.89

The insurance market risk capital component is 3% of the "adjusted mathematical reserves" (as defined in PRU 7.2.89A R) for all insurance liabilities except those of a kind which:

(1) arise from contracts of insurance falling in long-term insurance business classes III, VII or VIII to the extent that the firm does not bear any investment risk; or
(2) arise from contracts of insurance falling in long-term insurance business class V.

31/12/2005

Adjusted mathematical reserves

PRU 7.2.89A

(1) For the purpose of PRU 7.2.88 R and PRU 7.2.89 R, the "adjusted mathematical reserves" is the aggregate of the amounts which result from the performance of the calculation in PRU 7.2.90 R for each category of insurance liability specified in (2).
(2) The categories of insurance liability referred to in (1) are:

(a) for the purpose of PRU 7.2.88 R, those categories described in PRU 7.2.91 R (1), (2), (3), (4) and (5); and
(b) for the purpose of PRU 7.2.89 R, those categories described in PRU 7.2.91 R (1), (2), (4) and (5)

31/12/2005

PRU 7.2.90

The calculation referred to in PRU 7.2.89A R (1) is the multiplication of the amount of the mathematical reserves (gross of reinsurance cessions) in respect of a category of insurance liability by the higher of:

(1) 85% or, in the case of a pure reinsurer, 50%; and
(2) the ratio as at the end of the financial year in question of:

(a) the mathematical reserves in respect of that category of insurance liability net of reinsurance cessions; to
(b) the mathematical reserves in respect of that category of insurance liability gross of reinsurance cessions.

31/12/2005

PRU 7.2.91

For the purpose of PRU 7.2.89A R and PRU 7.2.90 R, the categories of insurance liability are as follows:

(1) liabilities of a kind which arise from contracts of insurance falling in long-term insurance business classes I, II or IX;
(2) liabilities of a kind which arise from contracts of insurance falling in long-term insurance business classes III, VII or VIII to the extent that the firm bears an investment risk;
(3) liabilities of a kind which arise from contracts of insurance falling in long-term insurance business classes III, VII or VIII to the extent that the firm bears no investment risk and where the allocation to cover management expenses in the contract of insurance has a fixed upper limit which is effective as a limit for a period exceeding 5 years from the commencement of the contract;
(4) liabilities of a kind which arise from contracts of insurance falling in long-term insurance business class IV; and
(5) liabilities of a kind which arise from contracts of insurance falling in long-term insurance business class VI.

31/12/2005

PRU 7.2.92

Where a firm has written a unit-linked contract, the firm's liability under the contract may consist of a unit liability, where the firm bears no investment risk, and other liabilities for which the firm bears an investment risk, and for which a separate reserve is held. PRU 7.2.91 R (2) and (3) require a firm to analyse its liabilities under unit-linked contracts between those for which it bears an investment risk and those for which it does not. PRU 7.2.88 R and PRU 7.2.89 R taken together result in a capital requirement for any liabilities for which the firm bears an investment risk of 4% of "adjusted mathematical reserves" (1% for expense risk and 3% for market risk).

31/12/2005

PRU 7.3

Mathematical reserves

01/10/2005

Application

PRU 7.3.1

PRU 7.3 applies to a long-term 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

Purpose

PRU 7.3.2

This section follows on from the overall requirement on firms to establish adequate technical provisions (see PRU 7.2.16 R). The mathematical reserves form the main component of technical provisions for long-term insurance business. PRU 7.3 sets out rules and guidance as to the methods and assumptions to be used in calculating the mathematical reserves. The rules and guidance set out the minimum basis for mathematical reserves. Methods and assumptions that produce reserves that are demonstrably equal to or greater than the minimum basis may also be used, though they must meet the basic requirements for methods and assumptions set out in PRU 7.3.7 R to PRU 7.3.27 G.

31/12/2004

PRU 7.3.3

This section applies to all firms carrying on long-term insurance business and implements some of the requirements contained in article 20 of the Consolidated Life Directive. The implementation is designed to ensure that a firm's mathematical reserves in respect of long-term insurance contracts meet the minimum requirements set by the Consolidated Life Directive. A firm may use a prospective or a retrospective method to value its mathematical reserves(see PRU 7.3.7 R).

31/12/2004

PRU 7.3.4

The required procedures are summarised in the flowchart in PRU 7 Annex 1G.

31/12/2004

PRU 7.3.5

Firms to which PRU 2.1.15R applies are required to calculate a with-profits insurance capital component (see PRU 2.1.34 R). In order to calculate its with-profits insurance capital component, such a firm is required to carry out additional calculations of its liabilities on a realistic basis (see PRU 7.4), which it is required to report to the FSA (see Forms 18,19). A firm that reports its liabilities on a realistic basis is referred to in PRU as a realistic basis life firm. Such firms are subject to different rules relating to the calculation of mathematical reserves (see PRU 7.3.46 R and PRU 7.3.76 R) compared with those that apply to firms that report on a regulatory basis only (regulatory basis only life firms).

31/12/2004

PRU 7.3.6

A number of the rules in this section require a firm to take into account its regulatory duty to treat customers fairly. In this section, references to such a duty are to a firm's duty to pay due regard to the interests of its customers and to treat them fairly (see Principle 6 in PRIN). This duty is owed to both policyholders and potential policyholders.

31/12/2004

Basic valuation method

PRU 7.3.7

(1) Subject to (2), a firm must establish its mathematical reserves using a prospective actuarial valuation on prudent assumptions of all future cash flows expected to arise under, or in respect of, each of its long-term insurance contracts.
(2) But a firm may use a retrospective actuarial valuation where:

(a) a prospective method cannot be applied to a particular type of contract; or
(b) the firm can demonstrate that the resulting amount of the mathematical reserves would be no lower than would be required by a prudent prospective actuarial valuation.

31/12/2004

PRU 7.3.8

A prospective valuation sets the mathematical reserves at the present value of future net cash flows. A retrospective method typically sets the mathematical reserves at the level of premiums received (and accumulated with investment return), less claims and expenses paid. A prospective valuation is preferred because it takes account of circumstances that might have arisen since the premium rate was set and of changes in the perception of future experience. Circumstances in which a retrospective valuation might be appropriate include:

(1) where the assumptions initially made in determining the premium rate were sufficiently prudent at inception and have not been overtaken by subsequent events; and
(2) where the liability depends on the emerging experience.

31/12/2004

PRU 7.3.9

Except in PRU 7.3.71 R (1), PRU 7.3 does not apply to final bonuses. In addition, for realistic basis life firms only, PRU 7.3 does not apply to other discretionary benefits, including future annual bonuses.

31/12/2005

Methods and assumptions

PRU 7.3.10

In the actuarial valuation under PRU 7.3.7 R, a firm must use methods and prudent assumptions which:

(1) are appropriate to the business of the firm;
(2) are consistent from year to year without arbitrary changes (see PRU 7.3.11 G);
(3) are consistent with the method of valuing assets (see PRU 1.3);
(4) include appropriate margins for adverse deviation of relevant factors (see PRU 7.3.12 G);
(5) recognise the distribution of profits (that is, emerging surplus) in an appropriate way over the duration of each contract of insurance;
(6) take into account its regulatory duty to treat its customers fairly (see Principle 6); and
(7) are in accordance with generally accepted actuarial practice.

31/12/2004

PRU 7.3.11

PRU 7.3.10 R (2) prohibits only arbitrary changes in methods and assumptions, that is, changes made without adequate reasons. Any such changes would hinder comparisons over time as to the amount of the mathematical reserves and so obscure trends in solvency and the emergence of surplus.

31/12/2004

PRU 7.3.12

The relevant factors referred to in PRU 7.3.10 R (4) may include, but are not limited to, factors such as future investment returns, expenses, mortality, morbidity, options, persistency and reinsurance (see also PRU 7.3.13 R to PRU 7.3.19 G).

31/12/2004

Margins for adverse deviation

PRU 7.3.13

The appropriate margins for adverse deviation required by PRU 7.3.10 R (4) must be sufficiently prudent to ensure that there is no significant foreseeable risk that liabilities to policyholders in respect of long-term insurance contracts will not be met as they fall due.

31/12/2004

PRU 7.3.14

The margins for adverse deviation are a prudential margin in respect of the risks that arise under a long-term insurance contract.

31/12/2004

PRU 7.3.15

PRU 7.3.13 R sets the normal standard of prudence required for margins. PRU 7.3.16 G suggests benchmarks against which a firm should compare the margins it has set in accordance with PRU 7.3.10 R (4) and PRU 7.3.13 R. PRU 7.3.17 G gives guidance where a market risk premium is not readily obtainable.

31/12/2004

PRU 7.3.16

When setting the margins for adverse deviation required by PRU 7.3.10 R (4) in relation to a particular contract, a firm should consider, where appropriate:

(1) the margin for adverse deviation included in the premium for similar long-term insurance contracts, if any, newly issued by the firm; and
(2) where a sufficiently developed and diversified market for transferring a risk exists, the risk premium that would be required by an unconnected party to assume the risk in respect of the contract.

The margin for adverse deviation of a risk should generally be greater than or equal to the relevant market price for that risk.

31/12/2004

PRU 7.3.17

Where a risk premium is not readily available, or cannot be determined, an external proxy for the risk should be used, such as adjusted industry mortality tables. Where there is a considerable range of possible outcomes, the FSA expects firms to use stochastic techniques to evaluate these risks. In time, for example, longevity risk, where this constitutes a significant risk for the firm, may fall into this category.

31/12/2004

PRU 7.3.18

The margins for adverse deviation should be recognised as profit only as the firm itself is released from risk over the duration of the contract.

31/12/2004

PRU 7.3.19

Further detailed rules and guidance on margins for adverse deviation are included in PRU 7.3.32 G to PRU 7.3.89 G. In particular, the cross-references for the different assumptions used in calculating the mathematical reserves are as follows:

(1) expenses (PRU 7.3.50 R to PRU 7.3.58 G);
(2) mortality and morbidity (PRU 7.3.59 R to PRU 7.3.61 G);
(3) options (PRU 7.3.62 R to PRU 7.3.72 G);
(4) persistency (PRU 7.3.73 G to PRU 7.3.77 G); and
(5) reinsurance (PRU 7.3.77A R to PRU 7.3.89 G).

The rules and guidance on margins for adverse deviation in respect of future investment returns, which are also required in the calculation of mathematical reserves, are set out in PRU 4.2.28 R to PRU 4.2.48 G.

31/12/2005

Record keeping

PRU 7.3.20

A firm must make, and retain for an appropriate period, a record of:

(1) the methods and assumptions used in establishing its mathematical reserves, including the margins for adverse deviation, and the reasons for their use; and
(2) the nature of, reasons for, and effect of, any change in approach, including the amount by which the change in approach increases or decreases its mathematical reserves.

31/12/2004

PRU 7.3.21

PRU 1.4.53 R requires firms to maintain accounting and other records for a minimum of three years, or longer as appropriate. For the purposes of PRU 7.3.20 R, a period of longer than three years will be appropriate for a firm's long-term insurance business. In determining an appropriate period, a firm should have regard to:

(1) the detailed rules and guidance on record keeping in PRU 1.4.51 G - PRU 1.4.64 G;
(2) the nature and term of the firm's long-term insurance business; and
(3) any additional provisions or statutory requirements applicable to the firm or its records.

31/12/2004

Valuation of individual contracts

PRU 7.3.22

(1) Subject to (2) and (3), a firm must determine the amount of the mathematical reserves separately for each long-term insurance contract.
(2) Approximations or generalisations may be made where they are likely to provide the same, or a higher, result.
(3) A firm must set up additional mathematical reserves on an aggregated basis for general risks that are not specific to individual contracts.

31/12/2004

PRU 7.3.23

PRU 7.3.22 R to PRU 7.3.89 G set out rules and guidance for the separate prospective valuation of each contract. These may be applied instead to groups of contracts where the conditions set out in PRU 7.3.22 R (2) are satisfied.

31/12/2005

Contracts not to be treated as assets

PRU 7.3.24

A firm must not treat a long-term insurance contract as an asset.

31/12/2004

PRU 7.3.25

A separate prospective valuation for each contract may identify contracts for which the value of future cash inflows exceeds that of outflows, that is, the contracts have an asset value, rather than liability value. However, the surrender value of a contract is always greater than or equal to zero and the Consolidated Life Directive requires that no contract should be valued at less than its guaranteed surrender value. As a result, no contract should be treated as an asset.

31/12/2004

Avoidance of future valuation strain

PRU 7.3.26

(1) A firm must establish mathematical reserves for a contract of insurance which are sufficient to ensure that, at any subsequent date, the mathematical reserves then required are covered solely by:

(a) the assets covering the current mathematical reserves; and
(b) the resources arising from those assets and from the contract itself.

(2) For the purposes of (1), the firm must assume that:

(a) the assumptions adopted for the current valuation of liabilities remain unaltered and are met; and
(b) discretionary benefits and charges will be set so as to fulfil its regulatory duty to treat its customers fairly.

(3) (1) may be applied to a group of similar contracts instead of to the individual contracts within that group.

31/12/2004

PRU 7.3.27

The valuation of each contract, or group of similar contracts, should allow for the possibility, where it exists, that contracts may be surrendered (wholly or in part), lapsed or made paid-up at any time. The valuation assumptions include margins for adverse deviation (see PRU 7.3.13 R). PRU 7.3.26 R requires mathematical reserves to be established such that, if future experience is in line with the valuation assumptions, there would be no future valuation strain.

31/12/2004

Cash flows to be valued

PRU 7.3.28

In a prospective valuation, a firm must include the following in the cash flows to be valued:

(1) future premiums (see PRU 7.3.35 G to PRU 7.3.47 G);
(2) expenses, including commissions (see PRU 7.3.50 R to PRU 7.3.58 G);
(3) benefits payable (see PRU 7.3.29 R); and
(4) amounts to be received or paid in respect of the long-term insurance contracts under contracts of reinsurance or analogous non-reinsurance financing agreements (see PRU 7.3.77A R to PRU 7.3.89 G).

31/12/2005

PRU 7.3.29

For the purpose of PRU 7.3.28 R (3), benefits payable include:

(1) all guaranteed benefits including guaranteed surrender values and paid-up values;
(2) vested, declared and allotted bonuses to which the policyholder is entitled;
(3) all options available to the policyholder under the terms of the contract; and
(4) discretionary benefits payable in accordance with the firm's regulatory duty to treat its customers fairly.

31/12/2004

PRU 7.3.30

All cash flows are to be valued using prudent assumptions in accordance with generally accepted actuarial practice. Cash flows may be omitted from the valuation calculations provided the reserves obtained as a result of leaving those cash flows out of the calculation are not less than would have resulted had all cash flows been included (see PRU 7.3.22 R (2)). Provision for future expenses in respect of with-profits insurance contracts (excluding accumulating with-profits policies) may be made implicitly, using the net premium method of valuation (see PRU 7.3.43 R below). For the purposes of PRU 7.3.28 R (2), any charges included in expenses should be determined in accordance with the firm's regulatory duty to treat its customers fairly.

31/12/2004

PRU 7.3.31

PRU 7.3.29 R (4) requires regulatory basis only life firms to make allowance for any future annual bonus that a firm would expect to grant, assuming future experience is in line with the assumptions used in the calculation of the mathematical reserves. Final bonuses do not have to be taken into consideration in these calculations except in relation to accumulating with-profits policies (see PRU 7.3.9 R). The calculations required for accumulating with-profits policies are set out in PRU 7.3.71 R (1). For realistic basis life firms, except for accumulating with-profits policies, the mathematical reserves may be calculated without taking into account discretionary benefits, including both annual bonuses and final bonuses. For such firms full allowance for discretionary benefits is made in the calculation of the realistic value of liabilities (see PRU 7.4.105 R (5)).

31/12/2005

Valuation assumptions: detailed rules and guidance

PRU 7.3.32

More detailed rules and guidance about the valuation of cash flows are set out in PRU 7.3.33 R to PRU 7.3.89 G.

31/12/2005

Valuation rates of interest

PRU 7.3.33

In calculating the present value of future net cash flows, a firm must determine the rates of interest to be used in accordance with PRU 4.2.28 R to PRU 4.2.47 R.

31/12/2004

PRU 7.3.34

The rules in PRU 4.2.28 R to PRU 4.2.47 R set out the approach firms must take in setting margins for adverse deviation in the interest rates assumed in calculating the mathematical reserves. This includes a margin to allow for adverse deviation in market risk and, where relevant, credit risk. The requirements set out in PRU 4.2.28 R to PRU 4.2.47 R protect against the market risk that the return actually achieved on assets may fall below the market yields on assets at the actuarial valuation date.

31/12/2004

Future premiums

PRU 7.3.35

PRU 7.3.46 R and PRU 7.3.47 G apply to the valuation of with-profits insurance liabilities for a realistic basis life firm. PRU 7.3.38 R to PRU 7.3.45 G apply to a regulatory basis only life firm.

31/12/2004

PRU 7.3.36

For non-profit insurance contracts no specific method of valuation for future premiums is required by PRU. However, the method of valuation used should be sufficiently prudent taking into account, in particular, the risk of voluntary discontinuance by the policyholder.

31/12/2004

Future premiums: firms reporting only on a regulatory basis

PRU 7.3.37

PRU 7.3.38 R to PRU 7.3.43 R apply to a regulatory basis only life firm.

31/12/2004

PRU 7.3.38

(1) This rule applies to with-profits insurance contracts except accumulating with-profits policies written on a recurring single premium basis.
(2) The value attributed to a premium due in any future financial year (a future premium) must not exceed the lower of the value of:

(a) the actual premium payable under the contract; and
(b) the net premium.

(3) The net premium may be increased for deferred acquisition costs in accordance with PRU 7.3.43 R.

31/12/2004

PRU 7.3.39

The valuation method for future premiums in PRU 7.3.38 R retains the difference, if any, between the gross premium and the net premium as an implicit margin available to finance future bonuses, expenses and other costs. It thus helps to protect against the risk that adequate resources may not be available in the future to meet those costs.

31/12/2004

PRU 7.3.40

Where the terms of a contract of insurance have changed since it was first entered into, a firm must apply one of the methods in PRU 7.3.41 R in determining the net premium for the purpose of PRU 7.3.38 R (2)(b).

31/12/2004

PRU 7.3.41

A firm must treat the change referred to in PRU 7.3.40 R as if either:

(1) it had been included in the original contract but came into effect from the time the change became effective; or
(2) the original contract were cancelled and replaced by a new contract (with an initial premium paid on the new contract equal to the liability under the original contract immediately prior to the change); or
(3) it gave rise to two separate contracts where:

(a) all premiums are payable under the first contract and that contract provides only for such benefits as those premiums could have purchased from the firm at the date the change became effective; and
(b) no premiums are payable under the second contract and that contract provides for all the other benefits.

31/12/2004

PRU 7.3.42

PRU 7.3.41 R permits three alternative methods. However, the third method is only possible where a meaningful comparison can be made between the terms of the contract (as changed) and the terms upon which the firm was effecting its new contracts of insurance at the time the contract was changed.

31/12/2004

Future net premiums: adjustment for deferred acquisition costs

PRU 7.3.43

(1) The amount of any increase to the net premium for deferred acquisition costs must not exceed the equivalent of the recoverable acquisition expenses spread over the period of premium payments and calculated in accordance with the rates of interest, mortality and morbidity assumed in calculating the mathematical reserves.
(2) For the purpose of (1), recoverable acquisition expenses means the amount of expenses, after allowing for the effects of taxation, which it is reasonable to expect will be recovered from future premiums payable under the contract.
(3) The recoverable acquisition expenses in (1) must not exceed the lower of:

(a) the value of the excess of actual premiums over net premiums; and
(b) 3.5% of the relevant capital sum.

(4) Recoverable acquisition expenses may be calculated as the average for a group of similar contracts weighted by the relevant capital sum for each contract.

31/12/2004

PRU 7.3.44

PRU 7.3.43 R allows a firm to spread acquisition costs over the lifetime of a contract of insurance, but only if it is reasonable to expect those costs to be recoverable from future premium income from that contract. Further prudence is provided by the limitation of recoverable acquisition expenses to 3.5% of the relevant capital sum. This adjustment for acquisition costs is sometimes termed a Zillmer adjustment.

31/12/2004

PRU 7.3.45

In determining the extent, if any, to which it is reasonable to expect acquisition costs to be recoverable from future premium income, the firm should make prudent assumptions as to levels of voluntary discontinuance by policyholders.

31/12/2004

Future premiums: firms also reporting with-profits insurance liabilities on a realistic basis

PRU 7.3.46

(1) Subject to (2), for a realistic basis life firm, the future premiums to be valued in the calculation of the mathematical reserves for its with-profits insurance contracts must not be greater than the gross premiums payable by the policyholder.
(2) This rule does not apply to accumulating with-profits policies written on a recurring single premium basis (see PRU 7.3.48 R).

31/12/2004

PRU 7.3.47

The gross premium is the full amount of premium payable by the policyholder to the firm. The gross premium method contrasts with the net premium method which is required from regulatory basis only life firms (see PRU 7.3.37 R to PRU 7.3.45 G).

31/12/2004

Future premiums: accumulating with-profits policies

PRU 7.3.48

(1) This rule applies to accumulating with-profits policies written on a recurring single premium basis.
(2) A firm must not attribute any value to a future premium under the contract.
(3) Any liability arising only upon the payment of that premium may be ignored except to the extent that the value of that liability upon payment would exceed the amount of that premium.

31/12/2004

PRU 7.3.49

PRU 7.3.48 R prohibits a firm from taking credit for recurring single premiums under accumulating with-profits policies. As there is no contractual commitment to pay any future premiums the amount and timing of which are uncertain, the recognition of any potential margins would not be prudent. Where the payment of a future premium would give rise to a liability in excess of the premium a provision should be established.

31/12/2004

Expenses

PRU 7.3.50

(1) A firm must make provision for expenses, either implicitly or explicitly, in its mathematical reserves of an amount which is not less than the amount expected, on prudent assumptions, to be incurred in fulfilling its long-term insurance contracts.
(2) For the purpose of (1), expenses must be valued:

(a) after taking account of the effect of taxation;
(b) having regard to the firm's actual expenses in the last 12 months before the actuarial valuation date and any increases in expenses expected to occur in the future;
(c) after making prudent assumptions as to the effects of inflation on future increases in prices and earnings; and
(d) at no less than the level that would be incurred if the firm were to cease to transact new business 12 months after the actuarial valuation date.

(3) A firm must not rely upon an implicit provision arising from the method of valuing future premiums except to the extent that:

(a) it is reasonable to assume that expenses will be recoverable from future premiums; and
(b) the expenses would only arise if the future premiums were received.

31/12/2004

PRU 7.3.51

For with-profits insurance contracts where the net premium valuation method applies, an implicit provision arises because the future premiums valued are limited to the net premium adjusted as permitted by PRU 7.3.43 R. This excludes the allowance within the gross premium for expenses (other than recoverable acquisition expenses). It also excludes other margins within the actual premium that are a prudential margin in respect of the risks that arise under the contract or that are needed to provide for future discretionary benefits. To the extent that these other margins are not needed for the purpose for which they were originally established, they may also constitute an implicit provision for expenses.

31/12/2004

PRU 7.3.52

An implicit provision may also arise for other types of long-term insurance contract where, for example, no value is attributed to future premiums, but the firm is entitled to make deductions from future regular premiums before allocating them to secure policyholder benefits.

31/12/2004

PRU 7.3.53

A firm should only reduce the provision for future expenses to take account of expected taxation recoveries related to those expenses where recovery is reasonably certain, and after taking into account the assumption that the firm ceases to transact new business 12 months after the actuarial valuation date. An appropriate adjustment for discounting should be made where receipt of the taxation recoveries is not expected until significantly after the expenses are incurred.

31/12/2004

PRU 7.3.54

The firm's actual expenses in the 12 months prior to the actuarial valuation date may serve as a guide to the assumptions for future expenses, taking into consideration the mix of acquisition and renewal expenses. The expense assumptions should not be reduced to account for expected future improvements in efficiency until such efficiency improvements result in a reduced level of actual expenditure. However, the assumptions should take account of all factors which might increase costs including earnings and price inflation.

31/12/2004

PRU 7.3.55

The provisions for expenses (whether implicit or explicit) required by PRU 7.3.50 R must be sufficient to cover all the expenses of running off the firm's existing long-term insurance business including:

(1) all discontinuance costs (for example, redundancy costs and closure costs) that would arise if the firm were to cease transacting new business 12 months after the actuarial valuation date in circumstances where (and to the extent that) the discontinuance costs exceed the projected surplus available to meet such costs;
(2) all costs of continuing to service the existing business taking into account the loss of economies of scale from, and any other likely consequences of, ceasing to transact new business at that time; and
(3) the lower of:

(a) any projected valuation strain from writing new business for the 12 months following the actuarial valuation date to the extent the actual amount of that strain exceeds the projected surplus on prudent assumptions from existing business in the 12 months following the actuarial valuation date; and
(b) any projected new business expense overrun from writing new business for the 12 months following the actuarial valuation date to the extent the projected expenses exceed the expenses that the new business can support on a prudent basis.

31/12/2004

PRU 7.3.56

The provision for future expenses, whether implicit or explicit, should include a prudent margin for adverse deviation in the level and timing of expenses (see PRU 7.3.13 R to PRU 7.3.19 G). The margin should cover the risk of underestimating expenses whether due to, for example, initial under-calculation or subsequent increases in the amount of expenses. In setting the amount of the margin, the firm should take into account the extent to which:

(1) an appropriately validated method based on reliable data is used to allocate expenses by product type, by distribution channel and as between acquisition and non-acquisition expenses;
(2) the volume of existing and new business and its distribution by product type or distribution channel is stable or predictable;
(3) costs vary in the short, medium or long term dependent upon the volume of existing or new business and its distribution by product type or distribution channel; and
(4) cost control is well-managed.

31/12/2004

PRU 7.3.57

In setting the margin, the firm should also take into account:

(1) the length of the period over which it is necessary to project costs;
(2) the extent to which it is reasonable to expect inflation to be stable or predictable over that period; and
(3) whether, if inflation is higher than expected, it is reasonable to expect that the excess would be offset by increases in investment returns.

31/12/2004

PRU 7.3.58

Where a firm has entered into an agreement with any other person for the sharing or reimbursement of costs, in setting the margin it should take into account the potential impact of that agreement and of its discontinuance.

31/12/2004

Mortality and Morbidity

PRU 7.3.59

A firm must set the assumptions for mortality and morbidity using prudent rates of mortality and morbidity that are appropriate to the country or territory of residence of the person whose life or health is insured.

31/12/2004

PRU 7.3.60

The rates of mortality or morbidity should contain prudent margins for adverse deviation (see PRU 7.3.13 R to PRU 7.3.19 G). In setting those rates, a firm should take account of:

(1) the systems and controls applied in underwriting long-term insurance contracts and whether they provide adequate protection against anti-selection (that is, selection against the firm) including:

(a) adequately defining and identifying non-standard risks; and
(b) where such risks are underwritten, allocating to them an appropriate weighting;

(2) the nature of the contractual exposure to mortality or morbidity risk including:

(a) whether lower mortality increases or decreases the firm's liability;
(b) the period of cover and whether risk charges can be varied during that period and, if so, how quickly; and
(c) whether the options in the contract give rise to a significant risk of anti-selection (for example, opportunities for voluntary discontinuance, guaranteed renewal at the option of the policyholder and rights for conversion of benefits);

(3) the credibility of the firm's actual experience as a basis for projecting future experience including:

(a) whether there is sufficient data (especially for medical or financial risks and for new types of benefit or new methods of distribution); and
(b) whether the data is reliable and has been appropriately validated;

(4) the availability and reliability of:

(a) any published tables of mortality or morbidity for the country or territory of residence of the person whose life or health is insured; and
(b) any other information as to the industry-wide insurance experience for that country or territory;

(5) anticipated or possible future trends in experience including, but only where they increase the liability:

(a) anticipated improvements in mortality;
(b) changes arising from improved detection of morbidity (including critical illnesses);
(c) diseases the impact of which may not yet be reflected fully in current experience; and
(d) changes in market segmentation (such as impaired life annuities) which, in the light of developing experience, may require different assumptions for different parts of the policy class.

31/12/2004

PRU 7.3.61

An additional provision for diseases covered by PRU 7.3.60 G (5)(c) may be needed, in particular for unit-linked policies. In determining whether such a provision is needed a firm may take into consideration any ability to increase product charges commensurately (provided that such increase does not infringe on its regulatory duty to treat its customers fairly), but a provision would still be required for the period until such an increase could be brought into effect.

31/12/2004

Options

PRU 7.3.62

When a firm establishes its mathematical reserves in respect of a long-term insurance contract, the firm must include an amount to cover any increase in liabilities which might be the direct result of its policyholder exercising an option under, or by virtue of, that contract of insurance. Where the surrender value of a contract is guaranteed, the amount of the mathematical reserves for that contract at any time must be at least as great as the value guaranteed at that time.

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PRU 7.3.63

An option exists where a policyholder is given a choice between alternative forms of benefit, for example, a choice between receiving a cash benefit upon maturity or an annuity at a guaranteed rate. In some cases, the contract may designate one or other of these alternatives as the principal benefit and any other as an option. This designation, in itself, is not one of substance in the context of reserving since it does not affect the policyholder's choices. Other forms of option include:

(1) the right to convert to a different contract on guaranteed terms;
(2) the right to increase cover on guaranteed terms;
(3) the right to a specified amount on surrender; and
(4) the right to a paid up value.

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PRU 7.3.64

The firm should provide for the benefit which the firm anticipates the policyholder is most likely to choose. Except for the "option" of voluntary discontinuance in the case of regulatory basis only life firms (see PRU 7.3.74 R), past experience may be used as a guide, but only if this is likely to give a reasonable estimate of future experience. For example, past experience of the take-up of a cash payment option instead of an annuity would not be a reliable guide, if, in the past, market rates exceeded those guaranteed in the annuity but no longer do so. Similarly, past experience on the take-up of options may not be relevant in the light of the assumptions made in respect of future interest rates and mortality rates in the valuation of the benefits.

31/12/2004

PRU 7.3.65

Many options are long-term and need careful consideration. Improving longevity, for example, can increase the value of guaranteed annuity options vesting further in the future. Firms also need to have regard to the fact that policyholder behaviour can change in the future as policyholders become more aware of the value of their options. The impact on policyholder behaviour of possible changes in taxation should also be considered.

31/12/2004

PRU 7.3.66

In accordance with PRU 7.3.7 R and PRU 7.3.13 R, take-up rates for guaranteed annuity options should be assessed on a prudent basis with assumptions that include margins for adverse deviation (see PRU 7.3.13 R to PRU 7.3.19 G) that take account of current experience and the potential for future change. The firm should reserve for option take-up at least at a prudent margin over current experience for options shortly to vest. For longer term options where the option becomes increasingly valuable in the future due to projected mortality improvements, increased take-up rates should be assumed. In view of the growing uncertainty over take-up rates for projections further in the future, for guaranteed annuity option dates 20 years or more ahead at least a 95% take-up rate assumption should be made.

31/12/2004

PRU 7.3.67

Where there is considerable variation in the cost of the option depending on conditions at the time the option is exercised, and where that variation constitutes a material risk for the firm, it will generally be appropriate to use stochastic modelling. In this case prices from the asset model used in the stochastic approach should be benchmarked to relevant market asset prices before determining the value of the option. Where stochastic modelling is not undertaken, market option prices should be used to determine suitable assumptions for the valuation of the option. If no market exists for a particular option, a firm should take the value of the nearest equivalent benefit or right for which a market exists and document the way in which it has adjusted that valuation to reflect the original option.

31/12/2004

PRU 7.3.68

Where the option offers a choice between two non-discretionary financial benefits (such as between a guaranteed cash sum or a guaranteed annuity value, or between a unit value and a maturity guarantee) and where there is a wide range of possible outcomes, the firm should normally model such liabilities stochastically. In carrying out such modelling firms should take into account the likely choices to be made by policyholders in each scenario. Firms should make and retain a record of the development and application of the model.

31/12/2004

PRU 7.3.69

The value of a contract with an option is greater than the value of a similar contract without the option, that is, the option has value whether it is expected to be exercised or not. Although in theory a firm can rebalance its investments to match the expected cost of the option to the firm (including the time value of the option), this takes time to achieve and the market may move more quickly than the firm is able to respond. Also, there are likely to be transaction costs. Firms should take these aspects into consideration in setting up mathematical reserves.

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PRU 7.3.70

(1) Where a policyholder may opt to be paid a cash amount, or a series of cash payments, the mathematical reserves for the contract of insurance established under PRU 7.3.7 R must be sufficient to ensure that the payment or payments could be made solely from:

(a) the assets covering those mathematical reserves; and
(b) the resources arising from those assets and from the contract itself.

(2) In (1) references to a cash amount or a series of cash payments include the amount or amounts likely to be paid on a voluntary discontinuance.
(3) For the purposes of (1), the firm must assume that:

(a) the assumptions adopted for the current valuation remain unaltered and are met; and
(b) discretionary benefits and charges will be set so as to fulfil the firm's regulatory duty to treat its customers fairly.

(4) (1) may be applied to a group of similar contracts instead of to the individual contracts within that group except where the cash amount or series of cash payments is the amount or amounts likely to be paid on a voluntary discontinuance.

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PRU 7.3.71

For the purposes of PRU 7.3.70 R, a firm must assume that the amount of a cash payment secured by the exercise of an option is:

(1) in the case of an accumulating with-profits policy, the lower of:

(a) the amount which the policyholder would reasonably expect to be paid if the option were exercised, having regard to the representations made by the firm and including any expectations of a final bonus; and
(b) that amount, disregarding all discretionary adjustments;

(2) in the case of any other policy, the amount which the policyholder would reasonably expect to be paid if the option were exercised, having regard to the representations made by the firm, without taking into account any expectations regarding future distributions of profits or the granting of discretionary additions in respect of an established surplus.

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PRU 7.3.72

PRU 7.3.71 R (1) applies only to accumulating with-profits policies; PRU 7.3.71 R (2) applies to any other type of policy, including non-profit insurance contracts. In PRU 7.3.71 R (1)(a) a firm must take into consideration, for example, a market value adjustment where such an adjustment has been described in representations made to policyholders by the firm. However, any discretionary adjustment, such as a market value adjustment, must not be included in the amount calculated in PRU 7.3.71 R (1)(b).

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Persistency assumptions

PRU 7.3.73

PRU 7.3.76 R and PRU 7.3.77 G apply to the valuation of the with-profits insurance liabilities of realistic basis life firms. PRU 7.3.74 R and PRU 7.3.75 G apply to the valuation of all other liabilities.

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PRU 7.3.74

Except as permitted by PRU 7.3.76 R, a firm must not make any allowance in the calculation of the mathematical reserves for the voluntary discontinuance of any contract of insurance if the amount of the mathematical reserves so determined would, as a result, be reduced.

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PRU 7.3.75

The rate of voluntary discontinuance (that is, lapse, surrender or paying up) is often difficult to predict and may be volatile especially in the short term during stressful economic conditions. Depending upon the circumstances and contract terms, voluntary discontinuance may increase or decrease the firm's liability. In effect, PRU 7.3.74 R requires a firm to assume that there will be no voluntary discontinuance if assuming voluntary discontinuance would reduce the liability. This protects against the risk that arises from volatility in the rate of voluntary discontinuance. In addition, there is the risk of assets not being realisable when needed due to the rates of discontinuance exceeding expected levels.

31/12/2004

PRU 7.3.76

A realistic basis life firm may make assumptions about voluntary discontinuance rates in the calculation of the mathematical reserves for its with-profits insurance business provided that those assumptions meet the general requirements for prudent assumptions as set out in PRU 7.3.10 R and PRU 7.3.13 R.

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PRU 7.3.77

The prudential margin in respect of assumptions of voluntary discontinuance should be validated both in relation to recent experience and to variations in future experience that might arise as a result of reasonably foreseeable changes in conditions. In particular, where estimates of experience are being made well into the future, the assumptions should contain margins that take into account the increased risk of adverse experience arising from changed circumstances. Firms should also consider the possibility of anti-selection by policyholders and of variations in persistency experience for different classes and cohorts of business.

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Reinsurance

PRU 7.3.77A

In PRU 7.3.78 G to PRU 7.3.89 G references to:

(1) reinsurance and contracts of reinsurance include analogous non-reinsurance financing agreements, including contingent loans, securitisations and any other arrangements giving rise to charges on future surplus arising;
(2) reinsured risks, in relation to a contract of reinsurance entered into by a firm, means that part of:

(a) the risks insured by the firm under long-term insurance contracts entered into by it; and
(b) the other risks arising directly from the firm's long-term insurance business;

that have been transferred to the reinsurer under that contract of reinsurance; and
(3) reinsurance cash outflows include any reduction in policy liabilities recognised as covered under a contract of reinsurance or any reduction of any debt to the firm under or in respect of a contract of reinsurance.

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PRU 7.3.78

The prospective valuation of future cash flows to determine the amount of the mathematical reserves includes amounts to be received or paid under contracts of reinsurance in respect of long-term insurance business (see PRU 7.3.28 R (4)). This applies even where those cash flows cannot be identified as related to particular long-term insurance contracts (see PRU 7.3.22 R (3)).

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PRU 7.3.79

A firm must value reinsurance cash flows using methods and assumptions which are at least as prudent as the methods and assumptions used to value the underlying contracts of insurance which have been reinsured. In particular:

(1) reinsurance recoveries must not be recognised unless the underlying liabilities to which they relate have also been recognised;
(2) reinsurance cash outflows that are unambiguously linked to the emergence as surplus of margins included in the valuation of existing contracts of insurance or to the exercise by a reinsurer of its rights under a termination clause need not be valued (see PRU 7.3.85 R); and
(3) reinsurance cash inflows that are contingent on factors or conditions other than the reinsured risks must not be valued.

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PRU 7.3.80

In valuing reinsurance cash flows, a firm should establish prudent margins for adverse deviation (see PRU 7.3.13 R to PRU 7.3.19 G) including margins in respect of:

(1) any uncertainty as to the amount or timing of amounts to be paid or received; and
(2) the risk of credit default by the reinsurer.

31/12/2004

PRU 7.3.81

In assessing the risk of credit default, the firm should take into account the rules and guidance in PRU 3.2 (Credit risk in insurance).

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PRU 7.3.82

It will not necessarily be appropriate to use the same assumptions in PRU 7.3.79 R as for the underlying contracts. For example, if only a subgroup of the original contracts is reinsured, it may be appropriate to use different mortality rates.

31/12/2004

PRU 7.3.83

Only reinsurance cash inflows that are triggered unambiguously by the reinsured risks may be valued. Reinsurance cash inflows that depend on other contingencies where the outcome does not form part of the valuation basis should not be given credit.

31/12/2005

PRU 7.3.84

Firms should assess the extent of margins in the valuation of the existing contracts of insurance where these provide implicit provision for the reinsurance cash outflows in PRU 7.3.79 R. Where the reinsurance asset exceeds the estimated value of the future surplus under reinsured contracts firms should assess their credit risk exposure to the reinsurer.

31/12/2004

PRU 7.3.85

For the purposes of PRU 7.3.79 R (2), the "link" must be such that a contingent liability to pay or repay the amount to the reinsurer could not arise except when, and to the extent that, the margins in the valuation of the existing contracts of insurance emerge as surplus, or the reinsurer exercises its rights under a termination clause in the contract of reinsurance as a result of:

(1) fraudulent conduct by the firm under or in relation to the contract of reinsurance; or
(2) a representation as to the existence, at or before the time the contract of reinsurance is entered into, of a state of affairs which is within the knowledge or control of the firm and which is material to the reinsurer's decision to enter into the contract being discovered to be false; or
(3) the non-payment of reinsurance premiums by the firm; or
(4) a transfer by the firm of the whole or a specified part of its business without the agreement of the reinsurer, except where that agreement has been unreasonably withheld.

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PRU 7.3.86

For the purposes of PRU 7.3.79 R (2) and PRU 7.3.85 R, future surplus may only be offset against future reinsurance cash outflow in respect of surplus on non-profit insurance contracts and the charges or shareholder transfers arising as surplus from with-profits insurance contracts. Such charges and transfers may only be allowed for to the extent consistent with the regulatory duty of the firm to treat its customers fairly.

31/12/2004

PRU 7.3.87

For the purposes of PRU 7.3.85 R, a contingent liability means a liability that would only arise upon the happening of a particular contingency, even where that contingency is not expected to occur. For example, if the firm has a reinsurance arrangement in force that in the event the firm were wound up would give rise to repayments other than out of surplus emerging, the reinsurance cash outflows should be valued as a liability.

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PRU 7.3.88

PRU 7.3.85 R allows a firm not to value reinsurance cash outflows provided the contingencies in which the reinsurance would require repayment other than out of future surpluses are limited to termination clauses concerning fraud, material misrepresentation, non-payment of reinsurance premiums by the firm or a transfer of business by the firm without the agreement of the reinsurer, except if unreasonably withheld.

31/12/2005

PRU 7.3.89

Where the reinsurance cash outflow is payable by a fund or sub-fund that generates such profits, charges or transfers, the firm need make no provision for such payments provided that repayment to the reinsurer is linked unambiguously (as defined in PRU 7.3.85 R) to the emergence of future surplus. Where the profits, charges or transfers arising under a block of business are payable by a fund or sub-fund to another part of the firm then only where the firm has committed to remit such profits, charges or transfers directly to the reinsurer would it be acceptable for no provision for payments to the reinsurer to be made.

31/12/2004

PRU 7.3.90

In PRU 7.3.78 G to PRU 7.3.89 G references to reinsurance and contracts of reinsurance include analogous non-reinsurance financing agreements.

31/12/2004

PRU 7.3.91

In PRU 7.3.78 G to PRU 7.3.89 G references to reinsurance cash outflow include any provision for the reduction in policy liabilities recognised as covered under a contract of reinsurance or for the reduction of any debt to the firm previously created under a contract of reinsurance. In PRU 7.3.90 R analogous non-reinsurance financing agreements include contingent loans, securitisations and any other arrangements giving rise to charges on future surplus arising.

31/12/2004

PRU 7.4

With-profits insurance capital component

01/10/2005

Application

PRU 7.4.1

PRU 7.4 applies to a realistic basis life firm.

31/12/2004

PRU 7.4.2

A realistic basis life firm means a firm to which PRU 2.1.15 R applies. The application of PRU 2.1.15 R is set out in PRU 2.1.16 R and PRU 2.1.17 R. PRU 2.1.9 R requires that a firm must maintain at all times capital resources equal to or in excess of its capital resources requirement. The enhanced capital requirement forms part of the capital resources requirement for a realistic basis life firm. The with-profits insurance capital component forms part of the enhanced capital requirement which a realistic basis life firm is required to calculate in accordance with PRU 2.1.34 R.

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Purpose

PRU 7.4.3

This section sets out rules and guidance as to the methods and assumptions to be used in calculating the with-profits insurance capital component.

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PRU 7.4.4

The purpose of the with-profits insurance capital component is to supplement the mathematical reserves so as to ensure that a firm holds adequate financial resources for the conduct of its with-profits insurance business. In particular, capital in excess of the mathematical reserves may be needed to ensure that adequate final bonuses can be awarded to policyholders. That is, adequate in the sense that in setting bonuses payable to policyholders the firm pays due regard to the interests of its policyholders and treats them fairly. The mathematical reserves for a realistic basis life firm are not required to include provision for future annual bonuses or final bonuses (PRU 7.3.9 R).

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PRU 7.4.5

The required procedures are summarised in the flowchart in PRU 7 Annex 1G.

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Main requirements

PRU 7.4.6

A firm must calculate the with-profits insurance capital component in accordance with PRU 7.4.7 R.

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PRU 7.4.7

(1) The with-profits insurance capital component for a firm is the aggregate of any amounts that:

(a) result from the calculations specified in (2) and (3); and
(b) are greater than zero.

(2) Subject to (3), in relation to each with-profits fund within the firm, the firm must deduct B from A, where:

(a) A is the amount of the regulatory excess capital for that fund (see PRU 7.4.23 R); and
(b) B is the amount of the realistic excess capital for that fund (see PRU 7.4.32 R).

(3) Where a capital instrument that can be included in the firm's capital resources in accordance with PRU 2.2 has been attributed wholly or partly to a with-profits fund and that instrument meets the requirements of PRU 2.2.93 R, the firm must add to the amount calculated under (2) for that fund the result, subject to a minimum of zero, of deducting D from C where:

(a) C is the outstanding face amount of the instrument to the extent attributed to the fund; and
(b) D is the realistic value of the instrument to the extent attributed to the fund in the single event that determines the risk capital margin under PRU 7.4.43 R.

31/12/2004

PRU 7.4.8

Subordinated debt which is subordinated to policyholder interests (see PRU 2.2.93 R is an example of the sort of capital instrument that may give rise to a component of the WPICC under PRU 7.4.7 R (3). Such instruments are treated as capital under PRU 2.2, subject to the requirements of PRU 2.2.93 R. Under realistic reserving the capital instrument is valued as a realistic liability (PRU 7.4.40 R) and in calculating the risk capital margin such an instrument would be valued at its realistic value in the single event outlined in PRU 7.4.43 R (see also PRU 7.4.162 R). Overall, the effect of PRU 2.2, PRU 7.4.7 R (3) and PRU 7.4.43 R is to enable a firm that obtains subordinated debt to benefit from additional capital resources equal to the face amount of that debt.

31/12/2004

PRU 7.4.9

SUP 4 (Actuaries) sets out the role and responsibilities of the actuarial function and of the with-profits actuary.

(1) As part of his duties under SUP 4.3.13 R, the actuary appointed by the firm to perform the actuarial function must calculate the firm's mathematical reserves and, in the context of the calculation of the with-profits insurance capital component, must also:

(a) advse the firm's governing body on the methods and assumptions to be used in the calculation of the firm's with-profits insurance capital component;
(b) perform tihat calculation in accordance with the methods and assumptions determined by the firm's governing body; and
(c) report to the firm's governing body on the results of that calculation.

(2) As part of his duties under SUP 4.3.16 G, the with-profits actuary must advise the firm's governing body on the discretion exercised by the firm. In the context of the calculation of the with-profits insurance capital component, the with-profits actuary must also advise the firm's governing body as to whether the methods and assumptions (including the allowance for management actions) used for that calculation are consistent with the firm's Principles and Practices of Financial Management (PPFM - see COB 6.10 ) and with its regulatory duty to treat its customers fairly.

31/12/2004

Definitions

PRU 7.4.10

In this section, real estate means an interest in land, buildings or other immovable property.

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PRU 7.4.11

In this section, the long-term gilt yield is the annualised equivalent of the yield on the 15-year index for United Kingdom Government fixed-interest securities jointly compiled by the Financial Times, the Institute of Actuaries and the Faculty of Actuaries.

31/12/2004

PRU 7.4.12

For the purposes of this section, a firm has an exposure to an asset or liability where the firm's valuation of its assets or liabilities changes when the value of the asset or liability changes.

31/12/2004

PRU 7.4.13

Unless the context otherwise requires, all references (however expressed) in this section to realistic liabilities, or to liabilities which are included in the calculation of realistic liabilities, include discretionary benefits payable by the firm in accordance with the firm's regulatory duty to treat its customers fairly.

31/12/2004

PRU 7.4.14

In this section, any reference to a firm's regulatory duty to treat its customers fairly is a reference to the firm's duty under Principle 6 (Customers' interests). This states that a firm must pay due regard to the interests of its customers and treat them fairly.

31/12/2004

PRU 7.4.15

In this section, any reference to the Principles and Practices of Financial Management (PPFM) is a reference to the requirements in COB 6.10 (Principles and Practices of Financial Management) for firms to establish, maintain and record the principles and practices of financial management according to which the business of its with-profits funds is conducted.

31/12/2004

PRU 7.4.16

The extent to which a firm requires a separate PPFM for each of its with-profits funds will depend on the firm's circumstances and any relevant representations made by the firm to its with-profits policyholders. In this section, any reference to a firm's PPFM refers to the PPFM which relate to the with-profits fund or the with-profits insurance contracts in question.

31/12/2004

Record keeping

PRU 7.4.17

A firm must make, and retain for an appropriate period of time, a record of:

(1) the methods and assumptions used in making any calculation required for the purposes of this section (and any subsequent changes) and the reasons for their use; and
(2) any change in practice and the nature of, reasons for, and effect of, any change in approach with respect to those methods and assumptions.

31/12/2004

PRU 7.4.18

PRU 1.4.53 R requires firms to maintain accounting and other records for a minimum of three years, or longer as appropriate. For the purposes of PRU 7.4.17 R, a period of longer than three years will be appropriate for a firm's long-term insurance business. In determining an appropriate time period, a firm should have regard to:

(1) the detailed guidance on record keeping in PRU 1.4.51 G to PRU 1.4.64 G;
(2) the nature and term of the firm's long-term insurance contracts; and
(3) any additional provisions or statutory requirements applicable to the firm or its records.

31/12/2004

PRU 7.4.19

A firm must also identify in the record required to be kept by PRU 7.4.17 R changes in practice, in particular changes in those items which will or may be significant in relation to the eventual claim values.

31/12/2004

PRU 7.4.20

Some of the changes identified in accordance with PRU 7.4.19 R may have to be notified to the firm's policyholders in accordance with the firm's PPFM.

31/12/2004

General principles for allocating aggregate amounts

PRU 7.4.21

Where any calculation is required under this section which:

(1) is to be made in respect of any with-profits fund of a firm; and
(2) covers an amount that is otherwise calculated in relation to the firm as a whole;

the firm must make an allocation of that amount as between all of its funds (including funds which are not with-profits funds).

31/12/2004

PRU 7.4.22

In any case where:

(1) non-profit insurance contracts are written in any with-profits fund of a firm; and
(2) any calculation is required under this section which:

(a) is to be made in respect of the regulatory excess capital or realistic excess capital for the fund; and
(b) covers an amount that is otherwise calculated or allocated in relation to the fund as a whole;

the firm must make an allocation of the amount in (2)(b) as between the with-profits insurance contracts and non-profit insurance contracts written in the fund.

31/12/2004

Calculation of regulatory excess capital

PRU 7.4.23

A firm must calculate the regulatory excess capital for each of its with-profits funds by deducting B from A, where:

(1) A is the regulatory value of assets of the fund (PRU 7.4.24 R); and
(2) B is the sum of:

(a) the regulatory value of liabilities of the fund (PRU 7.4.29 R);
(b) the long-term insurance capital requirement in respect of the fund's with-profits insurance contracts; and
(c) the resilience capital requirement in respect of the fund's with-profits insurance contracts.

31/12/2004

Regulatory value of assets

PRU 7.4.24

(1) For the purposes of PRU 7.4.23 R (1), the regulatory value of assets of a with-profits fund is equal to the sum of:

(a) the amount of the fund's long-term admissible assets; and
(b) the amount of any implicit items allocated to that fund;

less an amount, representing any non-profit insurance contracts written in that fund, determined in accordance with (2).
(2) Where non-profit insurance contracts are written in a with-profits fund, the amount representing those contracts is the sum of:

(a) the mathematical reserves in respect of the non-profit insurance contract written in the fund; and
(b) the following amounts, to the extent that each of them is covered by the fund's long-term admissible assets:

(i) an amount in respect of the non-profit insurance contracts written in the fund which represents an appropriate allocation of the firm's long-term insurance capital requirement; and
(ii) an amount in respect of the non-profit insurance contracts written in the fund which represents an appropriate allocation of the firm's resilience capital requirement.

31/12/2004

PRU 7.4.25

For the purpose of determining the value of a fund's long-term admissible assets in accordance with PRU 7.4.24 R (1)(a), no value is to be attributed to:

(1) debts owed by reinsurers; or
(2) claims; or
(3) tax recoveries; or
(4) claims against compensation funds;

to the extent already offset in the calculation of technical provisions.

31/12/2005

PRU 7.4.26

In making a determination in accordance with PRU 7.4.24 R (2), a firm must allocate long-term admissible assets of an appropriate nature and term to any non-profit insurance contracts written in the with-profits fund.

31/12/2004

PRU 7.4.27

In calculating the amount of a firm's resilience capital requirement allocated to the non-profit insurance contracts in the with-profits fund, the firm should calculate the amount of resilience capital that would be required if that business were in a stand-alone company owning the assets allocated. The resilience capital requirement for the with-profits insurance business should also be calculated as if it were a stand-alone company. An allocation of the firm's total resilience capital requirement should then be made in a manner that would produce a result materially consistent with an allocation in proportion to the amounts calculated for each part of the business as stand-alone entities.

31/12/2004

PRU 7.4.28

A firm needs to obtain an implicit item waiver from the FSA in order to bring in an amount under PRU 7.4.24 R (1)(b). For guidance on applying for an implicit item waiver in respect of future surpluses relating to with-profits funds see PRU 2 Annex 2. The amount of any implicit item allocated to a with-profits fund may be defined in the terms of any waiver granted.

31/12/2004

Regulatory value of liabilities

PRU 7.4.29

For the purposes of PRU 7.4.23 R (2)(a), the regulatory value of liabilities of a with-profits fund is equal to the sum of:

(1) the mathematical reserves, in respect of the fund's with-profits insurance contracts, including the value of any provisions reflecting bonuses allocated at the actuarial valuation date; and
(2) the regulatory current liabilities of the fund (see PRU 7.4.30 R).

31/12/2004

PRU 7.4.30

For the purposes of PRU 7.4.29 R (2), the regulatory current liabilities of a with-profits fund are equal to the sum of the following amounts to the extent that they relate to that fund:

(1) accounting liabilities (including long-term insurance liabilities which have fallen due before the end of the financial year);
(2) liabilities from deposit back arrangements; and
(3) any provision for adverse variations (determined in accordance with PRU 4.3.17 R).

31/12/2004

PRU 7.4.31

The amount of regulatory current liabilities for a with-profits fund refers to the sum of the amounts in (1) and (2) in respect of the fund:

(1) the amount of 'Total other insurance and non-insurance liabilities'; and
(2) the amount of 'Cash bonuses which had not been paid to policyholders prior to the end of the financial year';

as disclosed at lines 49 and 12 respectively of the appropriate Form 14 ('Long-term business liabilities and margins') for that fund as part of the Annual Returns required to be deposited with the FSA under IPRU(INS) rule 9.6(1).

31/12/2004

Calculation of realistic excess capital

PRU 7.4.32

A firm must calculate the realistic excess capital for each of its with-profits funds by deducting B from A, where:

(1) A is the realistic value of assets of the fund (see PRU 7.4.33R); and
(2) B is the sum of:

(a) the realistic value of liabilities of the fund (see PRU 7.4.40 R); and
(b) the risk capital margin for the fund (see PRU 7.4.43 R).

31/12/2004

Realistic value of assets

PRU 7.4.33

(1) For the purposes of PRU 7.4.32 R (1), the realistic value of assets of a with-profits fund is the sum of:

(a) the amount of the fund's regulatory value of assets determined in accordance with PRU 7.4.24 R, but with no value given to any implicit items and excluding the regulatory value of any shares in a related undertaking which carries on long-term insurance business;
(b) the amount of the fund's excess admissible assets (see PRU 7.4.36 R);
(c) the present value of future profits (or losses) on any non-profit insurance contracts written in the with-profits fund (see PRU 7.4.37 R);
(d) the value of any derivative or quasi-derivative held in the fund (see PRU 1.3.11 R to PRU 1.3.30 R) to the extent its value is not reflected in (a), (b) or (c);
(e) any amount determined under (2); and
(f) the amount of any prepayments made from the fund.

(2) Where any equity shares held (directly or indirectly) by a firm (A):

(a) are shares in a related undertaking (B) which carries on long-term insurance business; and
(b) have been identified by A under PRU 7.4.21 R as long-term insurance assets which are held in the with-profits fund for which the realistic value is to be determined under (1);
the amount required under (1)(e) is the relevant proportion of the value of all B's equity shares as determined in (3).

(3) For the purposes of (2):

(a) the relevant proportion is the proportion of the total number of equity shares issued by B which are held (directly or indirectly) by A;
(b) the value of all B's equity shares must be taken as D deducted from C, where C is equal to the sum of:

(i) the shareholder net assets of B;
(ii) any surplus assets in the non-profit funds of B;
(iii) any additional amount arising from the present value of future profits (or losses) on any non-profit insurance contracts written by B (calculated on a basis consistent with PRU 7.4.37 R), excluding any amount arising from business that is written in a with-profits fund; and
(iv) where B has any with-profits funds, the present value of projected future transfers out of those funds to shareholder funds of B;
and D is equal to the sum of:
(v) the long-term insurance capital requirement in respect of any non-profit insurance contracts written in a non-profit fund of B;
(vi) the amount of the resilience capital requirement in respect of any non-profit insurance contracts written in a non-profit fund of B;
(vii) any part of the with-profits insurance capital component of B, or of B's long-term insurance capital requirement or resilience capital requirement in respect of B's with-profits insurance contracts, that is not covered from the assets of the with-profits fund from which it arises after deducting from those assets the amount calculated under (iv); and
(viii) any assets of B that back its regulatory capital requirements and that are valued in (iii) in the calculation of the present value of future profits of non-profit insurance business written by B.

(4) The methods and assumptions used in the calculations under (3)(b)(iii) and (iv) must follow a consistent approach to that set out in PRU 7.4.37 R.

31/12/2005

PRU 7.4.34

In PRU 7.4.33 R (1)(d), where a derivative or quasi-derivative has a positive asset value, credit should be given within the realistic value of assets. If the derivative or quasi-derivative has a negative asset value it should be valued within realistic liabilities as an element of realistic current liabilities (see PRU 7.4.40 R (3)).

31/12/2004

PRU 7.4.35

Where a firm identifies shares in a related undertaking which carries on long-term insurance business as shares held in one of its with-profits funds, PRU 7.4.33 R (1)(e), PRU 7.4.33 R (2) and PRU 7.4.33 R (3) bring in a realistic valuation of the related undertaking equal to its net assets plus the present value of future profits, less its regulatory capital requirements (see PRU 7.4.33 R (3)(v), (vi) and (vii)). Where the related undertaking has taken the present value of future profits arising from its contracts into consideration in covering its regulatory capital requirements (for example, its risk capital margin, under PRU 7.4.45 R (2)(c)), PRU 7.4.33 R (3)(b)(iii) requires a firm to exclude those future profits in valuing the related undertaking. The subtraction of the capital requirements in the calculation provides a straightforward method of allowing for the change in the related undertaking's value in stress conditions, as the value of the related undertaking is not subject to the realistic stress tests of the risk capital margin. In calculating the present value of future profits on non-profit insurance business written in the related undertaking under PRU 7.4.33 R (3)(b)(iii), a firm may value the release of capital requirements as the business runs off (see PRU 7.4.38 G). PRU 7.4.33 R (3)(b)(viii) ensures that any such capital is not double-counted.

31/12/2004

PRU 7.4.36

Excess admissible assets of a with-profits fund means admissible assets which exceed any of the percentage limits referred to in PRU 3.2.22 R.

31/12/2004

PRU 7.4.37

A firm must calculate the present value of future profits (or losses) on non-profit insurance contracts written in the with-profits fund using methodology and assumptions which:

(1) are based on current estimates of future experience;
(2) involve reasonable (but not excessively prudent) adjustments to reflect risk and uncertainty;
(3) allow for a market-consistent valuation of any guarantees or options within the contracts valued;
(4) are derived from current market yields, having regard to International Financial Reporting Standard 4: Insurance Contracts, as if it were being applied to determine the value under that standard for the first time;
(5) have regard to generally accepted actuarial practice and generally accepted industry standards appropriate for firms carrying on long-term insurance business;
(6) are consistent with the allocation, made in accordance with PRU 7.4.22 R, of any aggregate amounts as between the with-profits insurance contracts and the non-profit insurance contracts written in the fund;
(7) allow for any tax that would be payable out of the with-profits fund in respect of the contracts valued; and
(8) are consistent with the allocation, made in accordance with PRU 7.4.26 R, of long-term admissible assets as between the with-profits insurance contracts and any non-profit insurance contracts written in the fund.

31/12/2005

PRU 7.4.38

In calculating the present value of future profits (or losses) for non-profit insurance business required by PRU 7.4.33 R (1)(c), to the extent that the long-term insurance capital requirement and the resilience capital requirement are covered by the with-profits fund's long-term admissible assets, a firm may take into consideration any release of these items as the relevant policies go off the books.

31/12/2004

PRU 7.4.39

Annuities do not typically fall to be valued on a market-consistent basis under PRU 7.4.37 R (3) as they are not "options and guarantees" as defined for accounting purposes. This is because they do not have "time value" in the option-pricing meaning of that term. However where, atypically, annuities do fall to be valued on a market-consistent basis under PRU 7.4.37 R (3), the discount rate used should be appropriate to the characteristics of the liability, including its illiquidity. The appropriate interest rate, therefore, would not typically be the risk-free rate. Where illiquid assets are used to closely match similar illiquid liabilities, as could be the case in annuities business, it would be appropriate to look at the liquidity premium that is implicit in the market value of the assets as a proxy for the liquidity premium that should be included in a market consistent valuation of the liabilities. However, care should be exercised in doing this. Assets and liabilities are rarely perfectly matched and an appropriate margin needs to be included in the valuation to cover the risk of unexpected mismatch.

31/12/2004

PRU 7.4.39A

In view of PRU 7.4.39 G, it is likely that the discount rate to be applied to the market-consistent valuation of those annuities that fall within the scope of PRU 7.4.37 R (3) would not be significantly different from that which applies to other annuities (to which a discount rate based on the return on the matching assets less an allowance for risk which is reasonable but not excessively prudent, in accordance with PRU 7.4.37 R (2), might be applied).

31/12/2005

PRU 7.4.39B

In determining current market yields for the purpose of PRU 7.4.37 R (4), a firm is required to have regard to IFRS 4 as if it were being applied to determine the value under that standard for the first time, that is, without reference to existing practices. Paragraph 27 of the standard is likely to be of particular relevance. A firm should not include an allowance for future investment margins until they are earned. In particular, a firm should not include an allowance for capital growth in determining current market yields for equities and real estate investments.

31/12/2005

Realistic value of liabilities: general

PRU 7.4.40

For the purposes of PRU 7.4.32 R (2)(a), the realistic value of liabilities of a with-profits fund is the sum of:

(1) the with-profits benefits reserve of the fund;
(2) the future policy related liabilities of the fund; and
(3) the realistic current liabilities of the fund.

31/12/2004

PRU 7.4.41

All liabilities arising under, or in connection with, with-profits insurance contracts written in the fund should be included in the realistic value of liabilities referred to in PRU 7.4.40 R, including those in respect of guarantees and the value of options.

31/12/2004

PRU 7.4.42

Detailed rules and guidance for the calculation of the three elements referred to in PRU 7.4.40 R are contained below in this section:

(1) PRU 7.4.116 R to PRU 7.4.135 G refer to the with-profits benefits reserve;
(2) PRU 7.4.136 G to PRU 7.4.189 G refer to the future policy related liabilities; and
(3) PRU 7.4.190 R and PRU 7.4.191 R refer to the realistic current liabilities.

31/12/2004

Risk capital margin

PRU 7.4.43

(1) A firm must calculate a risk capital margin for each of its with-profits funds in accordance with (2) to (6).
(2) The firm must identify relevant assets (PRU 7.4.45 R) which, in the most adverse scenario, will have a value (PRU 7.4.46 R) which is equal to the realistic value of liabilities of the fund under that scenario.
(3) The most adverse scenario means the single event comprising that combination of the scenarios in PRU 7.4.44 R which gives rise to the largest positive value that results from deducting B from A, where:

(a) A is the value of relevant assets which will produce the result described in (2); and
(b) B is the realistic value of liabilities of the fund.

(4) The risk capital margin for the fund is the result of deducting C from A, where C is the sum of:

(a) B; and
(b) any amount included within relevant assets under PRU 7.4.45 R (2)(c).

(5) In calculating the value of relevant assets for the purpose of determining the most adverse scenario in (3), a firm must not adjust the valuation of any asset taken into consideration under PRU 7.4.33 R (1)(e) (related undertakings carrying on long-term insurance business) or PRU 7.4.45 R (2)(c) (present value of future profits arising from insurance contracts written outside the with-profits fund).
(6) In calculating the realistic value of liabilities of a fund under any scenario, a firm is not required to adjust the best estimate provision made under PRU 7.4.190 R (1) in respect of a defined benefits pension scheme in accordance with PRU 7.4.191 R .

31/12/2004

PRU 7.4.44

For the purposes of PRU 7.4.43 R (3), the scenarios are one scenario selected from each of the following:

(1) in respect of UK and other assets within PRU 7.4.62 R (1)(a):

(a) the range of market risk scenarios identified in accordance with PRU 7.4.68 R (1) (equities);
(b) the range of market risk scenarios identified in accordance with PRU 7.4.68 R (2) (real estate); and
(c) the range of market risk scenarios identified in accordance with PRU 7.4.68 R (3) (fixed interest securities);

(2) in respect of non-UK assets within PRU 7.4.62 R (1)(b):

(a) the range of market risk scenarios identified in accordance with PRU 7.4.73 R (1) (equities);
(b) the range of market risk scenarios identified in accordance with PRU 7.4.73 R (2) (real estate); and
(c) the range of market risk scenarios identified in accordance with PRU 7.4.73 R (3) (fixed interest securities);

(3) the range of credit risk scenarios identified in accordance with PRU 7.4.78 R (1) (bond or debt items);
(4) the range of credit risk scenarios identified in accordance with PRU 7.4.78 R (2) (reinsurance items or analogous non-reinsurance financing agreements);
(5) the range of credit risk scenarios identified in accordance with PRU 7.4.78 R (3) (other items including derivatives and quasi-derivatives); and
(6) the persistency risk scenario identified in accordance with PRU 7.4.100R.

31/12/2004

PRU 7.4.45

(1) In PRU 7.4.43 R, in relation to a with-profits fund, the relevant assets means a range of assets which meets the following conditions:

(a) the range is selected on a basis which is consistent with the firm's regulatory duty to treat its customers fairly;
(b) the range must include assets from within the with-profits fund the value of which is greater than or equal to the realistic value of liabilities of the fund;
(c) the range is selected in accordance with (2); and
(d) no asset of the firm may be allocated to the range of assets identified in respect of more than one with-profits fund.

(2) The range of assets must be selected from the assets specified in (a) to (c), in the order specified:

(a) assets that have a realistic value under PRU 7.4.33 R;
(b) where a firm has selected all the assets within (a), any admissible assets that are not identified as held within the with-profits fund; and
(c) where a firm has selected all the assets within (a) and (b), any additional assets.

(3) But a firm must not bring any amounts into account under (2)(b) or (2)(c) in respect of any with-profits fund if that would result in the firm exceeding its overall maximum limit (determined according to whether the firm has only one with-profits fund or more than one such fund).
(4) A firm exceeds its overall maximum limit for amounts brought into account under (2)(b) where:

(a) in the case of a firm with a single with-profits fund, the amount the firm brings into account in respect of that fund;
(b) in the case of a firm with two or more with-profits funds, the aggregate of the amounts the firm brings into account in respect of each of those funds;
exceeds the sum of the firm's shareholder net assets and the surplus assets in the firm's non-profits funds, less any regulatory capital requirements in respect of business written outside its with-profits funds.

(5) A firm exceeds its overall maximum limit for amounts brought into account under (2)(c) where:

(a) in the case of a firm with a single with-profits fund, the amount the firm brings into account in respect of that fund;
(b) in the case of a firm with two or more with-profits funds, the aggregate of the amounts the firm brings into account in respect of each of those funds;

exceeds 50% of the present value of future profits arising from insurance contracts written by the firm outside its with-profits funds.

31/12/2004

PRU 7.4.46

In valuing the relevant assets identified under PRU 7.4.43 R (2), a firm must use the same methods of valuation as in PRU 7.4.33 R, except that:

(1) the value of any admissible assets not identified as held within the with-profits fund (PRU 7.4.45 R (2)(b)) must be as determined under PRU 1.3; and
(2) the value of any asset which forms part of the range of assets as a result of PRU 7.4.45 R (2)(c) must be determined on a basis consistent with that described in PRU 7.4.37 R.

31/12/2004

PRU 7.4.47

The purpose of the risk capital margin for a with-profits fund is to cover adverse deviation from:

(1) the fund's realistic value of liabilities;
(2) the value of assets identified, in accordance with PRU 7.4.43 R (2), to cover the amount in (1) and the fund's risk capital margin;

arising from the effects of market risk, credit risk and persistency risk. Other risks are not explicitly addressed by the risk capital margin.

31/12/2004

PRU 7.4.48

The amount of the risk capital margin calculated by the firm for a with-profits fund will depend on the firm's choice of assets held to cover the fund's realistic value of liabilities and the margin. PRU 7.4.43 R requires the relevant assets to be sufficient, in the most adverse scenario, to cover the realistic value of liabilities in the event that scenario was to arise.

31/12/2004

PRU 7.4.49

PRU 7.4.45 R (2)(c) allows firms to bring the economic value of non-profit insurance business written outside a with-profits fund into the assets available to cover the risk capital margin. To place a prudent limit on the amount of future profits taken into consideration a maximum of 50% of the present value of non-profit insurance business can be taken into the calculation (PRU 7.4.45 R (5)). Where a contract is written in a non-profit fund but the assets arising from that contract are invested in a with-profits fund which is subject to charges for investment management or other services which benefit the non-profit fund, such charges can be taken into consideration in calculating the present value of future profits of the non-profit insurance business. Where a proportion of the present value of future profits on non-profit insurance business written outside a with-profits fund is brought in as an asset, no stress tests apply to this asset (see PRU 7.4.43 R (5)) as the amount taken into consideration is limited to 50% of the total present value.

31/12/2004

PRU 7.4.50

A firm using a stochastic approach in PRU 7.4.169 R (1) should keep recalibration in the post-stress scenarios to the minimum required to reflect any change in the underlying risk-free yields. A firm using the market costs of hedging approach, as in PRU 7.4.169 R (2), may assume in estimating the market cost of hedging in the post-stress scenarios that market volatilities are unchanged.

31/12/2004

PRU 7.4.51

In the scenario tests set out in PRU 7.4.62 R to PRU 7.4.103 G, firms are required to test for worst case scenarios across a range of assumptions. The tests are, with the exception of the credit risk test, two-sided, requiring both increases and decreases in the assumptions. The FSA does not expect a firm to investigate every possible stress, but a firm should be able to demonstrate that it is reasonable to assume that it has successfully identified the single event that determines the risk capital margin for the firm's business, as required by PRU 7.4.43 R (3).

31/12/2004

PRU 7.4.51A

In the scenario tests set out in PRU 7.4.62 R to PRU 7.4.103 G, a firm is required to assess the changed value of its assets and liabilities in the economic conditions of the most adverse scenario. A firm is required to assess the changed value of each relevant asset (as defined in PRU 7.4.45 R), notwithstanding any uncertainty about the appropriate valuation basis for that asset. In valuing an asset in the most adverse scenario, 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 most adverse scenario 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 most adverse scenario.

31/12/2005

Management actions

PRU 7.4.52

In calculating the risk capital margin for a with-profits fund, a firm may reflect, in its projections of the value of assets and liabilities under the scenarios in PRU 7.4.44R, the firm's prospective management actions (PRU 7.4.53 R).

31/12/2004

PRU 7.4.53

Prospective management actions refer to the foreseeable actions that would be taken by the firm's management, taking into account:

(1) an appropriately realistic period of time for the management actions to take effect; and
(2) the firm's PPFM and its regulatory duty to treat its customers fairly.

31/12/2004

PRU 7.4.54

The management actions in PRU 7.4.53 R may include, but are not limited to, changes in future bonus rates, reductions in surrender values, changes in asset dispositions (taking into account the associated selling costs) and changes in the amount of charges deducted from asset shares for with-profits insurance contracts.

31/12/2004

PRU 7.4.55

A firm should use reasonable assumptions in incorporating management actions into its projections of claims such that the mitigating effects of the management actions are not overstated. In modelling management actions, a firm should ensure consistency with its PPFM and take into account its regulatory duty to treat its customers fairly.

31/12/2004

PRU 7.4.56

In accordance with PRU 7.4.17 R, a firm should make and retain a record of the approach used, in particular the nature and effect of anticipated management actions (including, where practicable, the amount by which the actions would serve to reduce the projected values of assets and liabilities).

31/12/2004

PRU 7.4.57

A firm which deducts charges in respect of any adverse experience or cost of capital to with-profits insurance contracts should keep a record under PRU 7.4.17 R of the amount of any such charges to its customers and of how it has ensured their fair treatment.

31/12/2004

Policyholder actions

PRU 7.4.58

In calculating the risk capital margin for a with-profits fund, a firm must reflect, in its projections of the value of assets and liabilities under the scenarios in PRU 7.4.44 R, a realistic assessment of the actions of its policyholders (see PRU 7.4.59 R).

31/12/2004

PRU 7.4.59

Policyholder actions refer to the foreseeable actions that would be taken by the firm's policyholders, taking into account:

(1) the experience of the firm in the past; and
(2) the changes that may occur in the future if options and guarantees become more valuable to policyholders than in the past.

31/12/2004

PRU 7.4.60

A firm should use realistic assumptions in incorporating policyholder actions into its projections of claims such that any mitigating effects of policyholder actions are not overstated and any exacerbating effects of policyholder actions are not understated. In modelling policyholder actions, a firm should ensure consistency with its PPFM and take into account its regulatory duty to treat its customers fairly in determining the options and information that would be available to policyholders.

31/12/2004

PRU 7.4.61

In calculating the persistency scenario in PRU 7.4.100 R, a firm needs to make assumptions regarding the future termination rates exhibited by policies, at points described in particular in PRU 7.4.101 R. Such assumptions should be realistic. However, the firm must have regard to the economic scenarios being projected. For example, if the value of an option became significantly greater in a future scenario than in the recent past, then the behaviour of policyholders in taking up the option is likely to differ in this future scenario compared with the recent past.

31/12/2004

Market risk scenario

PRU 7.4.62

(1) For the purposes of PRU 7.4.44 R, the ranges of market risk scenarios that a firm must assume are:

(a) for exposures to UK assets and for exposures to non-UK assets within (2), the ranges of scenarios set out in PRU 7.4.68 R; and
(b) for exposures to other non-UK assets, the ranges of scenarios set out in PRU 7.4.73 R.

(2) The exposures to non-UK assets within this paragraph are:

(a) exposures which do not arise from a significant territory outside the United Kingdom (PRU 7.4.63 R); or
(b) exposures which do arise from a significant territory outside the United Kingdom but which represent less than 0.5% of the realistic value of assets of the with-profits fund, measured by market value.

31/12/2004

PRU 7.4.63

For the purposes of this section in relation to a with-profits fund, a significant territory is any country or territory in which more than 2.5% of the fund's realistic value of assets (by market value) are invested.

31/12/2004

PRU 7.4.63A

Guidance on how a firm should determine where particular assets are invested is provided in PRU 4.2.13B G.

31/12/2005

PRU 7.4.64

In determining its most adverse scenario, a firm applying PRU 7.4.68 R and PRU 7.4.73 R should consider separately possible movements in UK and non-UK markets. It should not assume that market prices in different markets move in a similar way at the same time. A firm should also allow for the effect of the other components of the single event comprising the combination of scenarios applicable under PRU 7.4.43 R.

31/12/2004

PRU 7.4.65

In relation to the market risk scenarios in PRU 7.4.68 R and PRU 7.4.73 R, the effect of PRU 7.4.52 R and PRU 7.4.58 R is that a firm may reflect management actions and must make a realistic assessment of policyholder actions in projecting the assets and liabilities in its calculation of the risk capital margin for a with-profits fund within the firm. This contrasts with the position for calculating the resilience capital requirement for the firm (PRU 4.2.9 G to PRU 4.2.26 R).

31/12/2004

PRU 7.4.66

In PRU 7.4.62 R to PRU 7.4.76 G, where there is reference to exposure to assets invested in a territory this should be interpreted as follows:

(1) for equities, a stock that is listed on a stock market in that territory or, if unlisted, the stock of a company that is incorporated in that territory;
(2) for bonds, one that is denominated in the currency of that territory, or issued by an institution incorporated in that territory;
(3) for real estate, a property that is located in that territory; and
(4) for derivatives, quasi-derivatives and other instruments, one where the assets to which the instrument is exposed are assets invested in that territory.

In PRU 7.4.62 R to PRU 7.4.76 G, a preference share should be subjected to the same stress tests as an equity share.

31/12/2004

PRU 7.4.67

The relevant assets identified under PRU 7.4.43 R (2) to calculate the risk capital margin may, in certain circumstances, include up to 50% of the present value of future profits arising from insurance contracts written by the firm outside its with-profits funds. PRU 7.4.43 R (5) exempts such an asset from the market risk stress tests.

31/12/2004

Market risk scenario for exposures to UK assets and certain non-UK assets

PRU 7.4.68

The range of market risk scenarios referred to in PRU 7.4.62(1)(a) is:

(1) a rise or fall in the market value of equities of up to the greater of:

(a) 10%; and
(b) 20%, less the equity market adjustment ratio (see PRU 7.4.71 R);

(2) a rise or fall in real estate values of up to 12.5%; and
(3) a rise or fall in yields on all fixed interest securities of up to 17.5% of the long-term gilt yield.

31/12/2004

PRU 7.4.69

For the purposes of PRU 7.4.68 R, a firm must:

(1) assume that yields on equities and real estate remain unchanged from those applicable at market levels before applying each scenario; and
(2) model a rise or fall in equity, real estate and fixed interest markets as if the movement occurred instantaneously.

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PRU 7.4.70

For example, where the long-term gilt yield is 6%, a change of 17.5% in that yield would amount to a change of 1.05 percentage points. For the purpose of the scenarios in PRU 7.4.68 R (3), the firm would assume a fall or rise of up to 1.05 percentage points in yields on all fixed interest securities.

31/12/2004

Equity market adjustment ratio

PRU 7.4.71

The equity market adjustment ratio referred to in PRU 7.4.68 R (1)(b) is:

(1) if the ratio calculated in (a) and (b) lies between 80% 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) 20%, if the ratio calculated in (1)(a) and (b) is less than 80%.

31/12/2004

PRU 7.4.72

In PRU 7.4.71(1)(b), the average value of the FTSE Actuaries All Share Index over any period of 90 calendar days means the arithmetic mean based on levels at the close of business on each of the days in that period on which the London Stock Exchange was open for trading.

31/12/2004

Market risk scenario for exposures to other non-UK assets

PRU 7.4.73

The range of market risk scenarios referred to in PRU 7.4.62 R (1)(b) is:

(1) an appropriate rise or fall in the market value of equities listed in that territory (PRU 7.4.75 G), which must be at least equal to the percentage determined in PRU 7.4.68 R (1);
(2) a rise or fall in real estate values in that territory of up to 12.5%; and
(3) a rise or fall in yields on all fixed interest securities of up to 17.5% of the nearest equivalent (in respect of the method of calculation) of the long-term gilt yield.

31/12/2004

PRU 7.4.74

For the purposes of PRU 7.4.73 R, a firm must:

(1) assume that yields on equities and real estate remain unchanged from those applicable at market levels before applying each scenario; and
(2) model a rise or fall in equity, real estate and fixed interest markets as if the movement occurred instantaneously.

31/12/2004

PRU 7.4.75

For the purposes of PRU 7.4.73 R (1), an appropriate rise or fall in the market value of equities to which a firm has exposure in a significant territory must be determined having regard to:

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

31/12/2004

PRU 7.4.76

For the purpose of PRU 7.4.75 G (1), an appropriate equity market index (or indices) for a territory should be such that:

(1) the constituents of the index (or indices) are reasonably representative of the nature of the equities to which the firm is exposed in that territory which are included in the relevant assets identified in accordance with PRU 7.4.43 R (2); and
(2) the frequency of, and historical data relating to, published values of the index (or indices) are sufficient to enable an average value(s) and historical volatility of the index (or indices) to be calculated over at least the three preceding financial years.

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General

PRU 7.4.77

(1) The purpose of the credit risk scenarios in PRU 7.4.78 R to PRU 7.4.99 G is to show the financial effect of specified changes in the general credit risk environment on a firm's direct (counterparty) and indirect credit risk exposures. The scenarios apply in relation to corporate bonds, debt, reinsurance and other exposures, including derivatives and quasi-derivatives. This is thus quite separate from any reference to allowance for credit risk in PRU 4.2.
(2) In the case of bonds and debts, the scenarios are described in terms of an assumed credit rating dependent on the widening of credit spreads - changes in bond and debt credit spreads will have a direct impact on the value of bond and debt assets. Credit ratings are intended to give an indication of the security of the income and capital payments for a bond - the higher the credit rating, the more secure the payments. The reaction of credit spreads to developments in markets for credit risk varies by credit rating and so the scenarios to be assumed for bonds and debts depend on their ratings. The credit spreads on bonds and debt represent compensation to the investor for the risk of default and downgrade, but also for illiquidity, price volatility and the uncertainty of recovery rates relative to government bonds. Credit spreads on bonds tend to widen during an economic recession to reflect the increased expectations that corporate borrowers may default on their obligations or be subject to rating downgrades.
(3) Changes in bond and debt credit spreads will also be indicative of a change in direct counterparty exposure in relation to reinsurance and other exposures including derivatives and quasi-derivatives.
(4) In addition, changes in bond and debt credit spreads may indirectly impact on credit exposures, for example by affecting the payments anticipated under credit derivative instruments.
(5) A firm will also need to allow for the effect of other components of the single event comprising the combination of scenarios applicable under PRU 7.4.43 R in assessing exposure to credit risk. For example, in the case of an equity put option and a fall in equity market values, the resulting increase in the level of exposure to the firm's counterparty for the option combined with a change in the quality of the counterparty should be allowed for.

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PRU 7.4.78

For the purposes of PRU 7.4.44 R, the range of credit risk scenarios that a firm must assume is:

(1) changes in value resulting from an increase in credit spreads by an amount of up to the spread stress determined according to PRU 7.4.84 R in respect of any bond or debt item;
(2) changes in value determined according to PRU 7.4.94 R in respect of any reinsurance item or any analogous non-reinsurance financing agreement item; and
(3) changes in value determined according to PRU 7.4.98 R for any other item (including any derivative or quasi-derivative).

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PRU 7.4.79

For the purposes of PRU 7.4.78 R, a firm must make appropriate allowance for any loss mitigation techniques to the extent that they are loss mitigation techniques relied on for the purpose of PRU 3.2.8 R in accordance with PRU 3.2.16 R and PRU 3.2.18 R.

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PRU 7.4.80

The change in asset or liability values to be determined in relation to a credit risk scenario for the purposes of PRU 7.4.43 R and PRU 7.4.44 R is the change in value which would arise on the occurrence of the relevant credit risk scenario as a result of bond, debt, reinsurance or other exposures whether or not there is a direct counterparty exposure.

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PRU 7.4.81

Where a bond or a debt item or reinsurance asset is currently in default, it may be ignored by a firm for the purpose of applying PRU 7.4.78 R.

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PRU 7.4.82

Where a bond or a debt item or a reinsurance asset is currently in default and has been specifically provisioned, in accordance with relevant accounting standards, a firm is not required to increase the existing default provisions to reflect a worsening of recovery rates.

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PRU 7.4.83

Where the credit risk scenarios in PRU 7.4.78 R to PRU 7.4.99 G require a firm to assume a change in current credit spread, or a direct change in market value, the firm must not change the risk-free yields used to discount future cash flows in calculating the revised realistic value of liabilities and realistic value of assets (PRU 7.4.43 R (2)) resulting from those credit risk scenarios.

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Spread stresses to be assumed for bonds and debt

PRU 7.4.84

(1) In PRU 7.4.78 R (1) the spread stress which a firm must assume for any bond or debt item is:

(a) for any bond or debt item issued or guaranteed by an organisation which is in accordance with PRU 7.4.87 R a credit risk scenario exempt organisation in respect of that item, zero basis points; and
(b) for any other bond or debt item:

(i) Y if the credit rating description of that other bond or debt item determined by reference to PRU 7.4.89 R is not "Highly speculative or very vulnerable"; and
(ii) otherwise the larger of Y and Z.

(2) For the purpose of (1)(b):

(a) Y is the product of the spread factor for that bond or debt item and the square root of S, where:

(i) the spread factor for a bond or debt item is the spread factor shown in the final column of Table PRU 7.4.90 R, in the row of that Table corresponding to the credit rating description of the bond or debt item determined for the purpose of this rule by reference to PRU 7.4.89 R; and
(ii) subject to (3), S is the current credit spread for a bond or debt item, expressed as a number of basis points, which the firm must determine as the current yield on that bond or debt item in excess of the current gross redemption yield on the government bond most similar to that bond or debt item in terms of currency of denomination and equivalent term; and

(b) Z is the change in credit spread expressed as a number of basis points that would result in the current market value of the bond or debt falling by 5%.

(3) Where, for the purposes of (2)(a)(ii), there is no suitable government bond, the firm must use its best estimate of the gross redemption yield that would apply for a notional government bond similar to the bond or debt item in terms of currency of denomination and equivalent term.

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PRU 7.4.85

For the purpose of PRU 7.4.84 R (1)(a), a guarantee must be direct, explicit, unconditional and irrevocable.

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PRU 7.4.86

(1) As an example, a bond item has the credit rating description "exceptional or extremely strong" and currently yields 49 basis points in excess of the most similar government bond. The spread factor for that bond item is 3.00 by reference to Table PRU 7.4.90 R. Since S is 49, the square root of S is 7 and the spread stress for that item is 3 times 7, that is, 21 basis points. The firm must consider the impact of an increase in spreads by up to 21 basis points for that item.
(2) As a further example, a bond item has the credit rating description "highly speculative or very vulnerable". For this bond, S is 400, being the current spread for that bond expressed as a number of basis points. The spread factor for the bond is 24.00. So the firm must consider the impact of an increase in spreads by up to 24.00 times 20 i.e. 480 basis points for that item. The bond is however of short duration and the reduction in market value resulting from an additional spread of 480 basis points is less than 5 per cent of its current market value. A 5 per cent reduction in its market value would result from a spread widening of 525 basis points. The firm must consider the impact of an increase in spreads by up to 525 basis points for that item by virtue of its credit rating description.
(3) The calculation of the credit spread on commercial floating rate notes warrants particular consideration. Suppose, for example, that a notional floating rate note guaranteed by the UK government would have a market consistent price of X. This price can be estimated based on an assumed distribution of future payments under the floating rate note, and the current forward gilt curve. Suppose further that the market price of the commercial floating rate note is Y, where Y is less than X. A firm could calculate what parallel upward shift in the forward gilt curve would result in the notional government-backed floating rate note having a market price of Y for an unchanged assumed distribution of future payments. The size of the resulting shift could then be taken as the credit spread on the commercial floating rate note.
(4) In arriving at the estimated gross redemption yield in PRU 7.4.84 R (3), the firm may have regard to any appropriate swap rates for the currency of denomination of the bond or debt item, adjusted to take appropriate account of observed differences between swap rates and the yields on government bonds.

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PRU 7.4.87

For the purposes of this section:

(1) an organisation is a credit risk scenario exempt organisation in respect of an item if the organisation is:

(a) the European Central Bank; or
(b) any central government or central bank which, in relation to that item, satisfies the conditions in (2); or
(c) a multilateral development bank which is listed in (3); or
(d) an international organisation which is listed in (4);

(2) the conditions in (1)(b) are that, for any claim against the central government or central bank denominated in the currency in which the item is denominated:

(a) a credit rating is available from at least one listed rating agency nominated in accordance with PRU 7.4.92 R; and
(b) the credit rating description in the first column of Table PRU 7.4.90 R corresponding to the lowest such credit rating is either "exceptionally or extremely strong" or "very strong";

(3) for the purposes of (1)(c) the listed multilateral development banks are:

(a) the International Bank for Reconstruction and Development;
(b) the International Finance Corporation;
(c) the Inter-American Development Bank;
(d) the Asian Development Bank;
(e) the African Development Bank;
(f) the Council of Europe Development Bank;
(g) the Nordic Investment Bank;
(h) the Caribbean Development Bank;
(i) the European Bank for Reconstruction and Development;
(j) the European Investment Bank;
(k) the European Investment Fund; and
(l) the Multilateral Investment Guarantee Agency;

(4) for the purposes of (1)(d) the listed international organisations are:

(a) the European Community;
(b) the International Monetary Fund; and
(c) the Bank for International Settlements.

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PRU 7.4.88

Under PRU 7.4.87 R (2), a firm needs to take account of the currency in which the claim is denominated when it is considering claims on or guaranteed by a central government or central bank. It is possible, for example, that a given central bank would be a credit risk scenario exempt organisation in respect of claims on it denominated in its domestic currency, while not being a credit risk scenario exempt organisation in respect of claims on it denominated in a currency other than its domestic currency - the central government or central bank may have been assigned different credit assessments depending on the currency in which the claim on it is denominated.

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PRU 7.4.89

(1) For the purposes of this section, the credit rating description of a bond or debt item is to be determined in accordance with (2) and (3).
(2) If the item has at least one credit rating nominated in accordance with PRU 7.4.92 R ("a rated item"), its credit rating description is:

(a) where it has only one nominated credit rating, the general description given in the first column of Table PRU 7.4.90 R corresponding to that rating; or
(b) where it has two or more nominated credit ratings and the two highest nominated ratings fall within the same general description given in the first column of that Table, that description; or
(c) where it has two or more nominated credit ratings and the two highest nominated ratings do not fall within the same general description given in the first column of that Table, the second highest of those two descriptions.

(3) If the item is not a rated item, its credit rating description is the general description given in the first column of Table PRU 7.4.90 R that most closely corresponds to the firm's own assessment of the item's credit quality.
(4) An assessment under (3) must be made by the firm for the purposes of the credit risk scenario having due regard to the seniority of the bond or debt and the credit quality of the bond or debt issuer.

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PRU 7.4.90

Table : Listed rating agencies, credit rating descriptions, spread factors

Credit Rating Description

Listed rating agencies

Spread Factor

A.M. Best Company

Fitch Ratings

Moody's Investors Service

Standard & Poor's Corporation

Exceptional or extremely strong

aaa

AAA

Aaa

AAA

3.00

Very strong

5.25

Strong

6.75

Adequate

bbb

BBB

Baa

BBB

9.25

Speculative or less vulnerable

15.00

Very speculative or more vulnerable

24.00

Highly speculative or very vulnerable

Below B

24.00

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PRU 7.4.91

Where listed rating agencies provide ratings by sub-category then all ratings should be allocated to the main ratings category (e.g. ratings sub-category A+ or A- would be allocated to the assigned ratings category "Strong").

31/12/2004

PRU 7.4.92

For the purposes of PRU 7.4.87 R and PRU 7.4.89 R, a firm may, subject to (1) to (5), nominate for use credit ratings produced by one or more of the rating agencies listed in PRU 7.4.93 R:

(1) if the firm decides to nominate for use for an item the credit rating produced by one or more rating agencies, it must do so consistently for all similar items;
(2) the firm must use credit ratings in a continuous and consistent way over time;
(3) the firm must nominate for use only credit ratings that take into account both principal and interest;
(4) if the firm nominates for use credit ratings produced by one of the listed rating agencies then the firm must use solicited credit ratings produced by that listed rating agency; and
(5) the firm may nominate for use unsolicited credit ratings produced by one or more of the listed rating agencies except where there are reasonable grounds for believing that any unsolicited credit ratings produced by the agency are used so as to obtain inappropriate advantages in the relationship with rated parties.

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PRU 7.4.93

In this section, a listed rating agency is:

(1) A.M. Best Company; or
(2) Fitch Ratings; or
(3) Moody's Investors Service; or
(4) Standard & Poor's Corporation.

31/12/2004

Credit risk scenario for reinsurance

PRU 7.4.94

(1) The contracts of reinsurance or analogous non-reinsurance financing agreements to which PRU 7.4.78 R (2) applies are those:

(a) into which the firm has entered;
(b) which represent an economic asset under the single event applicable under PRU 7.4.43 R (3); and
(c) which are material (individually or in aggregate).

(2) For the purposes of (1), no account is to be taken of reinsurance or analogous non-reinsurance financing arrangements between undertakings in the same group where:

(a) the ceding and accepting undertakings are regulated by the FSA or a regulatory body in a designated State or territory for insurance (including reinsurance);
(b) no subsequent cessions of the ceded risk which are material (individually or in aggregate) are made to subsequent accepting undertakings by accepting undertakings (including subsequent accepting undertakings) other than to subsequent accepting undertakings which are in the same group; and
(c) for any subsequent cession or cessions of the ceded risk which are material (individually or in aggregate) each of the ceding and accepting undertakings (including subsequent accepting undertakings) is regulated by the FSA or a regulatory body in a designated State or territory for insurance (including reinsurance).

(3) The change in value which a firm must determine for a contract of reinsurance or an analogous non-reinsurance financing agreement is the firm's best estimate of the change in realistic value which would result from changes in credit risk market conditions consistent, subject to (4), with the changes in credit spreads determined in accordance with PRU 7.4.78 R (1).
(4) For the purpose of (3), 5% should be replaced by 10% in PRU 7.4.84 R (2)(b).

31/12/2004

PRU 7.4.95

(1) Reinsurance and analogous non-reinsurance financing agreements entered into by the firm, either with or acting as a reinsurer, must be included within the scope of the scenario. The combined rights and obligations under a contract of reinsurance or an analogous non-reinsurance financing agreement may represent an economic asset or liability. The value placed by the firm on the reinsurance item or non-reinsurance financing item should allow for a realistic assessment of the risks transferred and the risks of counterparty default associated with the item. In the case of analogous non-reinsurance financing agreements, references to terms such as "reinsurer", "ceding undertakings" and "accepting undertakings" include undertakings which by analogy are reinsurers, ceding or accepting undertakings. Analogous non-reinsurance financing agreements include contingent loans, securitisations and any other arrangements giving rise to charges on future surplus arising.
(2) In assessing values in accordance with PRU 7.4.94 R, a firm may consider it appropriate to determine values by drawing an analogy with the approach in respect of bond and debt items set out in PRU 7.4.84 R. (This might be the case if, in economic terms, the item being valued sufficiently resembles a bond or debt item - an alternative approach might otherwise be preferred). If the firm does consider it appropriate to draw an analogy, the "credit spread" assumed should be consistent with the assumed default probabilities and the values placed on the reinsurance asset for the purposes of determining the realistic values of assets and liabilities. A firm may regard it as appropriate to have regard to any financial strength ratings applicable to the reinsurer, but if so should apply the same principles set out in PRU 7.4.92 R for the nomination of financial strength ratings. Table PRU 7.4.97 G provides guidance as to the allocation of spread factors which a firm may, by analogy, deem appropriate to apply. Appropriate allowance should be made for any change in the extent of the counterparty exposure under the assumed scenario.
(3) The changes in credit risk spreads determined for bond and debt items in accordance with PRU 7.4.78 R (1) are required to result in a reduction in market value for some items of 5% of their current value through the operation of PRU 7.4.84 R (2)(b). For reinsurance contracts and analogous non-reinsurance financing agreements, determining the change in value by reference to PRU 7.4.94 R (3) requires a firm to consider the possibility of counterparty default in changed credit risk market conditions. Where in the changed credit risk market conditions assumed to apply the firm's assessment of the counterparty risk would result in the asset being considered equivalent to "Highly speculative or very vulnerable", the reduction in value required is at least 10% of its current value. PRU 7.4.94 R (4) relates to this requirement.

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PRU 7.4.96

A financial strength rating of a reinsurer refers to a current assessment of the financial security characteristics of the reinsurer with respect to its ability to pay claims under its reinsurance contracts and treaties in accordance with their terms.

31/12/2004

PRU 7.4.97

Table: Listed rating agencies, financial strength descriptions and spread factors

Financial Strength Description

A.M. Best Company

Fitch Ratings

Moody's Investors Service

Standard & Poor's Corporation

Spread Factor

Superior, extremely strong

A++

AAA

Aaa

AAA

3.00

Superior, very strong

A+

5.25

Excellent or strong

A, A-

6.75

Good

B++,B+

BBB

Baa

BBB

9.25

Fair, marginal

B, B-

15.00

Marginal, weak

C++,C+

24.00

Unrated or very weak

Unrated or below C++,C+

Unrated or below B

24.00

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Credit risk scenario for other exposures (including any derivative or quasi-derivative)

PRU 7.4.98

For the purposes of PRU 7.4.78 R (3), the change in value which must be determined for any other item (including any derivative or quasi-derivative) which represents an economic asset under the single event applicable under PRU 7.4.43 R (3) is the firm's best estimate of the change in the realistic value of that item which would result from changes in credit risk market conditions consistent with the changes in credit spreads determined in accordance with PRU 7.4.78 R (1) and the changes in value determined in accordance with PRU 7.4.78 R (2).

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PRU 7.4.99

In applying PRU 7.4.98 R, a firm should assess the total impact on the value of the item resulting from the assumed changed credit risk market conditions. The total change in value may result from the interaction of a number of separate influences. For example, a widening of credit spreads may imply an impact on the amount exposed to counterparty default as well as on the likelihood of that default. Each factor influencing the change in value needs separate consideration. It should be assumed, both for determining amounts exposed to counterparty default and the likelihood of such default that there will be no change in the likelihood of default in relation to an item issued by or guaranteed by an organisation which is in respect of that item a credit risk scenario exempt organisation (PRU 7.4.87 R). PRU 7.4.77 G (5) is also relevant in this context.

31/12/2004

Persistency risk scenario

PRU 7.4.100

For the purposes of the persistency risk scenario in PRU 7.4.44 R (6), a firm must allow for the effects of an increase or a decrease in persistency experience of its with-profits insurance contract by adjusting the termination rates in each year of projection by 32.5% of the termination rates assumed in the calculation of the realistic value of liabilities in PRU 7.4.40 R.

31/12/2004

PRU 7.4.101

The termination rates referred to in PRU 7.4.100 R are the rates of termination (including the paying-up of policies, but excluding deaths, maturities and retirements) other than on dates specified by the firm where:

(1) a guaranteed amount applies as the minimum amount which will be paid on claim; or
(2) any payments to the policyholder cannot be reduced at the discretion of the firm by its applying a market value adjustment.

31/12/2004

PRU 7.4.102

For the purposes of PRU 7.4.100 R, the increase or decrease in termination rates must be applied to the projection of terminations up to policy guarantee dates and between policy guarantee dates, but not to the assumptions as to the proportion of policyholders taking up the guarantees at policy guarantee dates.

31/12/2004

PRU 7.4.103

PRU 7.4.100 R to PRU 7.4.102 R require firms to apply a persistency stress test to the realistic value of liabilities. Where a firm brings the present value of non-profit insurance business in a with-profits fund into the calculation of the realistic value of assets (see PRU 7.4.33R) there is no requirement to stress this asset for changes in persistency assumptions.

31/12/2004

Realistic value of liabilities: detailed provisions

PRU 7.4.104

PRU 7.4.40 R sets out the three elements comprising the realistic value of liabilities for a with-profits fund. The remainder of this section contains general rules and guidance on determining the realistic value of liabilities plus further detail relating to each of those elements separately, as follows:

(1) general rules and guidance in PRU 7.4.105 R to PRU 7.4.115 G;
(2) with-profits benefits reserve in PRU 7.4.116 R to PRU 7.4.135 G;
(3) future policy related liabilities in PRU 7.4.136 G to PRU 7.4.189 G; and
(4) realistic current liabilities in PRU 7.4.190 R and PRU 7.4.191 R.

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Methods and assumptions: general

PRU 7.4.105

In calculating the realistic value of liabilities for a with-profits fund, a firm must use methods and assumptions which:

(1) are appropriate to the business of the firm;
(2) are consistent from year to year without arbitrary changes (that is, changes without adequate reasons);
(3) are consistent with the method of valuing assets (PRU 1.3 );
(4) make full provision for tax payable out of the with-profits fund, based on current legislation and practice, together with any known future changes, and on a consistent basis with the other methods and assumptions used;
(5) take into account discretionary benefits which are at least equal to, and charges which are no more than, the levels required for the firm to fulfil its regulatory duty to treat its customers fairly;
(6) take into account prospective management actions (PRU 7.4.53 R) and policyholder actions (PRU 7.4.59 R);
(7) provide for shareholder transfers out of the with-profits fund as a liability of the fund;
(8) have regard to generally accepted actuarial practice; and
(9) are consistent with the firm's PPFM.

31/12/2004

PRU 7.4.106

More specific rules and guidance are set out below on some aspects of the methods and assumptions to be used in calculating the realistic value of liabilities for a with-profits fund. In contrast to the mathematical reserves requirements in PRU 7.3.10 R (4) and PRU 7.3.13 R, there is no requirement to include margins for adverse deviation of relevant factors in calculating the realistic value of liabilities. Assumptions need be no more prudent than is necessary to achieve a best estimate, taking into account the firm's PPFM and its regulatory duty to treat its customers fairly. Where there is no requirement for a PPFM, for example non-UK business, a firm should use assumptions that are consistent with the firm's documented approach to treating its customers fairly. A firm may judge that a margin should be included in its calculations to avoid an understatement of the realistic value of liabilities as a result of uncertainty, for example, either in its method or in its data.

31/12/2004

PRU 7.4.107

The amount and timing of tax charges affect the amount of assets available to meet policyholder liabilities. PRU 7.4.105 R (4) requires firms to provide fully for all tax payable out of the with-profits fund on a basis consistent with the other assumptions and methods used in deriving the realistic balance sheet. So, for example, all projections which underlie the realistic valuation of assets or liabilities must allow for taxation. The approach adopted should not give any credit for any reduction in tax deriving from future expenses or deficits which is attributable to future new business. For assets backing capital requirements it is not necessary to take into consideration future tax charges on investment income generated by those assets. However, firms should consider this aspect in their capital planning.

31/12/2004

PRU 7.4.108

PRU 7.4.105 R (7) requires firms to provide fully for shareholder transfers. Such transfers do not therefore count as capital in the with-profits fund. However, a firm may apply under section 148 of the Act for a waiver from this requirement. In exercising its discretion under section 148 of the Act, the FSA will have regard (among other factors) to whether a firm has put in place undertakings satisfactory to the FSA, including that future transfers will not be paid out of the firm by way of dividend.

31/12/2004

Valuation of contracts: General

PRU 7.4.109

(1) A firm must determine the amount of the with-profits benefits reserve or the future policy related liabilities for a with-profits fund by carrying out a separate calculation in relation to each with-profits insurance contract or for each group of similar contracts.
(2) Appropriate approximations or generalisations may be made where they are likely to provide the same, or a higher, result than a separate calculation for each contract.
(3) A firm must set up additional reserves on an aggregated basis for general risks which are not specific to individual contracts or a group of similar contacts where the firm considers the realistic value of liabilities may otherwise be understated.

31/12/2004

PRU 7.4.110

For the purpose of PRU 7.4.109 R (1), a group of similar contracts is such that the conditions in PRU 7.4.109 R (2) are satisfied.

31/12/2004

PRU 7.4.111

Where a firm has grouped individual contracts for the purpose of calculating the mathematical reserves for a with-profits fund (in accordance with PRU 7.3.22 R), the firm is not required to use the same grouping of contracts in calculating the with-profits benefits reserve or future policy related liabilities for that fund.

31/12/2004

PRU 7.4.112

In contrast to PRU 7.3.24 R for the mathematical reserves, treating individual contracts as an asset is not prohibited if, and to the extent that, this treatment does not conflict with a firm's regulatory duty to treat its customers fairly.

31/12/2004

PRU 7.4.113

In calculating the with-profits benefits reserve, an overall (grouped or pooled) approach may be appropriate under either of the two methods set out in PRU 7.4.116 R. In particular, the calculation of aggregate retrospective reserves (see PRU 7.4.118 R) and the projection of future cash flows (see PRU 7.4.128 R) based on suitable specimen policies is permitted.

31/12/2004

PRU 7.4.114

In calculating the future policy related liabilities, the grouping of policies for valuing the costs of guarantees, options or smoothing, and their representation by representative policies, is acceptable provided the firm can demonstrate that the grouping of policies does not materially misrepresent the underlying exposure and does not significantly misstate the costs. A firm should exercise care in grouping policies in order to ensure that the risk exposure is not inappropriately distorted by, for example, forming groups containing policies with guarantees that are "in the money" and policies with guarantees well "out of the money". A firm should also have regard to the effects of policyholder behaviour over time on the spread of the outstanding guarantees or options.

31/12/2004

PRU 7.4.115

Where a firm groups similar policies for the purpose of calculating the with-profits benefits reserve or the future policy related liabilities, the firm should carry out sufficient validation to be reasonably sure that the grouping of policies has not resulted in the loss of any significant attributes of the portfolio being valued.

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With-profits benefits reserve

PRU 7.4.116

A firm must calculate a with-profits benefits reserve for a with-profits fund using either:

(1) a retrospective calculation under PRU 7.4.118 R (the retrospective method); or
(2) a prospective calculation under PRU 7.4.128 R of all future cash flows expected to arise under, or in respect of, each of the with-profits insurance contracts written in that fund (the prospective method).

31/12/2004

PRU 7.4.117

Subject to PRU 7.4.105 R (2), a firm may use different methods under PRU 7.4.116 R for different types or generations of with-profits insurance contracts.

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Retrospective method

PRU 7.4.118

In the retrospective method of calculating a with-profits benefits reserve, a firm must calculate either the aggregate of the retrospective reserves in respect of each with-profits insurance contract or, to the extent permitted by PRU 7.4.109 R and PRU 7.4.110 R, the total retrospective reserve in respect of each group of with-profits insurance contracts.

31/12/2004

PRU 7.4.119

In calculating the retrospective reserve for a with-profits insurance contract, or the total retrospective reserve in respect of a group of with-profits insurance contracts, a firm must take account of at least the following:

(1) premiums received from the policyholder;
(2) any expenses incurred or charges made (including commissions);
(3) any partial benefits paid or due;
(4) any investment income on, and any increases (or decreases) in, asset values;
(5) any tax paid or payable;
(6) any amounts received (or paid) under contracts of reinsurance or analogous non-reinsurance financing agreements, where relevant to retrospective reserves;
(7) any shareholder transfers and any associated tax paid or payable; and
(8) any permanent enhancements to (or deductions from) the retrospective reserves made by the firm.

31/12/2004

PRU 7.4.120

In taking account of amounts in PRU 7.4.119 R (6), due regard should be had to the specific details of each relevant contract of reinsurance or analogous non-reinsurance financing agreement and the relationship between the amounts received (or paid) and the value of the benefit granted (or received) under the arrangement. This should take into consideration, for example, the risk of default and differences in the firm's realistic assessment of the risks transferred and the contractual terms for such transfer of risk. Analogous non-reinsurance financing agreements include contingent loans, securitisations and any other arrangements giving rise to charges on future surplus arising.

31/12/2004

PRU 7.4.121

Where allowance is made for shareholder transfers, this should be in respect of the accrued bonus entitlement reflected in the retrospective reserve. This would include both annual bonuses already declared and accrued final bonus. However, shareholder transfers in respect of surplus yet to be credited to retrospective reserves should not be charged to those reserves until the corresponding surplus is credited.

31/12/2004

PRU 7.4.122

In calculating retrospective reserves, a firm must have regard to its regulatory duty to treat its customers fairly and must ensure that its approach is consistent with its Principles and Practices of Financial Management.

31/12/2004

PRU 7.4.123

In calculating retrospective reserves, a firm must ensure its treatment of past cash flows, and of any future cash flows, is consistent with those cash flows valued in its prospective calculation of the future policy related liabilities for that fund in accordance with the rules in PRU 7.4.136 G to PRU 7.4.189 G.

31/12/2004

PRU 7.4.124

An example of PRU 7.4.123 R concerns future shareholder transfers. A firm must make adequate provision for future shareholder transfers within the future policy related liabilities (see PRU 7.4.165 R). The basis of provisioning needs to be consistent with the amounts accrued within retrospective reserves and the amounts already transferred out of the with-profits fund.

31/12/2004

PRU 7.4.125

Another example of the application of PRU 7.4.123 R relates to the reference in PRU 7.4.119 R (8) to past permanent enhancements to (or deductions from) retrospective reserves made by firms. This item may include past miscellaneous surplus (or losses) which have been credited to (or debited from) retrospective reserves. Any other enhancements (or deductions) made on a temporary basis and any future surplus (or losses) that firms intend to credit to (or debit from) retrospective reserves should be included under the future policy related liabilities (see PRU 7.4.137 R).

31/12/2004

PRU 7.4.126

Firms characteristically use a range of calculation methods to determine retrospective reserves. A firm's definition and calculation of retrospective reserves will depend on a number of factors. These include: the firm's practice; its administration and accounting systems; the extent of its historical records; and the composition of its with-profits portfolio. The rules and guidance for the retrospective method are drawn up to be sufficiently flexible to accommodate the diversity of calculation methods used by firms, rather than to enforce any particular method of calculation of retrospective reserves. PRU 7.4.119 R simply sets minimum standards that all retrospective methods must meet.

31/12/2004

PRU 7.4.127

For the purposes of PRU 7.4.119 R (2) and PRU 7.4.128 R (2), the phrases 'charges made' or 'charges to be made' refer to circumstances where types of risk (such as mortality risk, longevity risk and investment risk) are met by the firm or with-profits fund in return for a charge deducted by the firm from the with-profits benefits reserve.

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Prospective method

PRU 7.4.128

In the prospective method of calculating a with-profits benefits reserve, a firm must take account of at least the following cash flows:

(1) future premiums;
(2) expenses to be incurred or charges to be made, including commissions;
(3) benefits payable (PRU 7.4.129 R);
(4) tax payable;
(5) any amounts to be received (or paid) under contracts of reinsurance or analogous non-reinsurance financing agreements, where relevant to with-profits insurance contracts being valued; and
(6) shareholder transfers.

31/12/2004

PRU 7.4.129

For the purposes of PRU 7.4.128 R (3), benefits payable include:

(1) all guaranteed benefits, including guaranteed amounts payable on death and maturity, guaranteed surrender values and paid-up values;
(2) vested, declared and allotted bonuses to which policyholders are entitled; and
(3) future annual and final bonuses at least equal to the levels required for the firm to fulfil its regulatory duty to treat its customers fairly.

31/12/2004

PRU 7.4.130

A firm must value the cash flows listed in PRU 7.4.128 R using best estimate assumptions of future experience, having regard to generally accepted actuarial practice and taking into account the firm's PPFM and its regulatory duty to treat its customers fairly.

31/12/2004

PRU 7.4.131

The prospective method sets the with-profits benefits reserve at the net present value of future cash flows listed in PRU 7.4.128 R.

31/12/2004

PRU 7.4.132

In contrast to PRU 7.3.10 R (4) and PRU 7.3.13 R relating to the methods and assumptions used to value the mathematical reserves, there is no requirement to value future cash flows using assumptions that include margins for adverse deviation. Also there are no detailed rules as to the future yields on assets, discount rates, premium levels, expenses, tax, mortality, morbidity, persistency and reinsurance. A firm should make its own assessment as to the amount of these future cash flows including bonuses and discretionary surrender or transfer values. A firm should make a realistic assessment of longevity risk and asset default risk (including default risk arising under contracts of reinsurance or analogous non-reinsurance financing agreements) within the best estimate assumptions of future experience required by PRU 7.4.130 R.

31/12/2004

PRU 7.4.133

In valuing the future cash flows listed in PRU 7.4.128 R, the firm should use a projection term which is long enough to capture all material cash flows arising from the contract or groups of contracts being valued. If the projection term does not extend to the term of the last policy, the firm should check that the shorter projection term does not significantly affect the results.

31/12/2004

PRU 7.4.134

Where a firm expects to pay additional benefits that are not included in the cash flows listed in PRU 7.4.128 R, it must make adequate provision for these benefits in calculating the future policy related liabilities in accordance with the rules in PRU 7.4.136 G to PRU 7.4.189 G.

31/12/2004

PRU 7.4.135

The prospective assessment of the with-profits benefits reserve will usually be on a deterministic basis. A firm will have to make further provision in the future policy-related liabilities for, for example, the costs of potential asset fluctuations or policy options.

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Overview of liabilities

PRU 7.4.136

PRU 7.4.137 R lists the future policy related liabilities for a with-profits fund that form part of a firm's realistic value of liabilities in PRU 7.4.40 R. Detailed rules and guidance relating to particular types of liability and asset are set out in PRU 7.4.139 R to PRU 7.4.168 G. These are followed by rules and guidance that deal with certain aspects of several liabilities (that is, liabilities relating to guarantees, options and smoothing):

(1) PRU 7.4.169 R to PRU 7.4.186 G refer to valuing the costs of guarantees, options and smoothing; and
(2) PRU 7.4.187 R to PRU 7.4.189 G refer to the treatment of surplus on guarantees, options and smoothing.

31/12/2004

PRU 7.4.137

The future policy related liabilities for a with-profits fund are equal to the sum of amounts, as they relate to that fund, in respect of (1) to (11) to the extent each is valued as a liability less the sum of amounts, as they relate to that fund, in respect of (1) to (11) to the extent each is valued as an asset:

(1) past miscellaneous surplus (or deficit) planned to be attributed to the with-profits benefits reserve (see PRU 7.4.139 R);
(2) planned enhancements to the with-profits benefits reserve (see PRU 7.4.141 R);
(3) planned deductions for the costs of guarantees, options and smoothing from the with-profits benefits reserve (see PRU 7.4.144 R);
(4) planned deductions for other costs deemed chargeable to the with-profits benefits reserve (see PRU 7.4.146 R);
(5) future costs of contractual guarantees (other than financial options) (see PRU 7.4.148 R);
(6) future costs of non-contractual commitments (see PRU 7.4.154 R);
(7) future costs of financial options (see PRU 7.4.156 G);
(8) future costs of smoothing (see PRU 7.4.158 R);
(9) financing costs (see PRU 7.4.162 R);
(10) any other further liabilities required for the firm to fulfil its regulatory duty to treat its customers fairly; and
(11) other long-term insurance liabilities (see PRU 7.4.165 R).

31/12/2004

PRU 7.4.138

Some of the elements of the calculation set out in PRU 7.4.137 R may have already been taken into consideration in the calculation of the with-profits benefits reserve, either under the retrospective method (see PRU 7.4.118 R onwards) or the prospective method (see PRU 7.4.128 R onwards). Where this is the case, the adjustments made under PRU 7.4.137 R should be such that no double-counting arises.

31/12/2004

Past miscellaneous surplus (or deficit) planned to be attributed to the with-profits benefits reserve

PRU 7.4.139

In calculating the future policy related liabilities for a with-profits fund, a firm must allow for past miscellaneous surplus (or deficit) which it intends to attribute to the with-profits benefits reserve for that fund but which has not yet been permanently credited to (or debited from) the with-profits benefits reserve for that fund.

31/12/2004

PRU 7.4.140

Past miscellaneous surplus (or deficit) already permanently credited to (or debited from) the with-profits benefits reserve will have been included in the calculation of the with-profits benefits reserve in accordance with PRU 7.4.119 R (8).

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Planned enhancements to the with-profits benefits reserve

PRU 7.4.141

In calculating the future policy related liabilities for a with-profits fund, a firm must make provision for any future planned enhancements to the with-profits benefits reserve for that fund that cannot be financed out of the resources of the with-profits benefits reserve and future premiums.

31/12/2004

PRU 7.4.142

For the purposes of PRU 7.4.141 R, planned enhancements to the with-profits benefits reserve will arise when a firm has a contractual obligation, or a non-contractual commitment (arising from its regulatory duty to treat customers fairly), to enhance claims on some classes of policy (perhaps in the form of specially enhanced future bonus rates). In such circumstances, the present value of the costs of paying out a target asset share that is more than the projected with-profits benefits reserve for those classes of policy for which this practice is applicable should be included in the amount of the future policy related liabilities. For example, a firm may have a non-contractual commitment (arising from its regulatory duty to treat customers fairly) to pay enhanced benefits but have discretion not to make such payments in adverse circumstances. Such planned enhancements should be provided for in the realistic balance sheet, but allowance should be made for management action in the calculation of the risk capital margin.

31/12/2004

PRU 7.4.143

The valuation of claims in excess of targeted asset shares in respect of guarantees, options and smoothing, including those arising under guaranteed annuity rates, should be carried out in accordance with PRU 7.4.169 R to PRU 7.4.186 G.

31/12/2004

Planned deductions for the costs of guarantees, options and smoothing from the with-profits benefits reserve

PRU 7.4.144

Where a firm expects to deduct future charges from the with-profits benefits reserve for a with-profits fund to cover the costs of guarantees, options or smoothing for that fund, the firm must take credit for these future charges in calculating the future policy related liabilities for that fund.

31/12/2004

PRU 7.4.145

In calculating future policy related liabilities for a with-profits fund, a firm should take credit under PRU 7.4.137 R (3) for the present value of the future "margins" available in respect of charges deducted to cover the costs of guarantees, options and smoothing. PRU 7.4.188 R requires firms that accumulate the charges made less costs incurred to provide for any surplus on the experience account as a realistic liability. Any such provision should be made under PRU 7.4.137 R (5), PRU 7.4.137 R (7) or PRU 7.4.137R (8) depending on the nature of the charges made, and has no effect on the amount calculated under PRU 7.4.144 R.

31/12/2004

Planned deductions for other costs deemed chargeable to the with-profits benefits reserve

PRU 7.4.146

Where a firm expects to deduct future charges (other than those valued in PRU 7.4.144 R) from the with-profits benefits reserve for a with-profits fund, the firm must take credit for these future charges in calculating the future policy-related liabilities for that fund.

31/12/2004

PRU 7.4.147

A firm should take credit for the present value of the other future "margins" available. The circumstances where such margins may arise include:

(1) where a firm is targeting claims at less than 100% of the with-profits benefits reserve, the amount of such shortfall; and
(2) where a firm expects to deduct any future charges (other than those for guarantees, options and smoothing) from the with-profits benefits reserve.

31/12/2004

Future costs of contractual guarantees (other than financial options)

PRU 7.4.148

A firm must make provision for the costs of paying excess claim amounts for a with-profits fund where the firm expects that the amount in (1) may be greater than the amount in (2), calculated as at the date of claim:

(1) the value of guarantees arising under a policy or group of policies in the fund; and
(2) the fund's with-profits benefits reserve allocated in respect of that policy or group of policies.

31/12/2004

PRU 7.4.149

For the purposes of PRU 7.4.148 R, the future costs of guarantees cannot be negative.

31/12/2004

PRU 7.4.150

In carrying out projections to calculate the cost of guarantees under PRU 7.4.137 R the opening liability should be set equal to the with-profits benefit reserve (see PRU 7.4.118 R), adjusted for miscellaneous surplus or deficits (see PRU 7.4.137 R (1)) and planned enhancements (see PRU 7.4.141 R).

31/12/2004

PRU 7.4.151

In projecting forward the with-profits benefits reserve, adjusted as in PRU 7.4.150 G, to the date of claim for the purposes of PRU 7.4.148 R, the firm should use market consistent assumptions for the expected future premium and investment income (including realised and unrealised gains or losses), expenses and claims, any charges to be deducted, tax and any other item of income or outgo. This projection should be carried out on the same basis as is described in PRU 7.4.130 R.

31/12/2004

PRU 7.4.152

PRU 7.4.169 R to PRU 7.4.186 G contain further rules and guidance on the valuation of guarantees, options and smoothing.

31/12/2004

PRU 7.4.153

Some examples of contractual guarantees are:

(1) for conventional with-profits insurance contracts, guaranteed sums assured and bonuses on death, maturity or retirement; and

(2) for accumulating with-profits policies, guarantees at a point in time or guaranteed minimum bonus rates.

31/12/2004

Future costs of non-contractual commitments

PRU 7.4.154

A firm must make provision for future costs in addition to those in PRU 7.4.148 R where the firm expects to pay further amounts to meet non-contractual commitments to customers or pay other benefits that need to be provided to fulfil a firm's regulatory duty to treat its customers fairly.

31/12/2004

PRU 7.4.155

Some examples of these non-contractual commitments are:

(1) statements by the firm regarding the ability of policies to cover defined amounts, such as the repayment of a mortgage;
(2) statements by the firm regarding regular withdrawals from a policy being without penalty;
(3) guaranteed annuity and cash option rates being provided beyond the strict interpretation of the policy; and
(4) the costs of any promises to customers or other benefits that need to be provided to fulfil a firm's regulatory duty to treat its customers fairly.

31/12/2004

Future costs of financial options

PRU 7.4.156

Financial options include guaranteed annuity and cash option rates.

31/12/2004

PRU 7.4.157

PRU 7.4.169 R to PRU 7.4.186 G contain further rules and guidance on the valuation of options.

31/12/2004

Future costs of smoothing

PRU 7.4.158

A firm must make provision for future smoothing costs of a with-profits fund where the firm expects that the claims paid on a policy or group of policies in the fund will vary from the greater of:

(1) the value of guarantees determined in PRU 7.4.148 R in respect of that policy or group of policies; and

(2) the fund's with-profits benefits reserve allocated in respect of that policy or group of policies which must be enhanced as described in PRU 7.4.141 R;

calculated as at the date of claim.

31/12/2004

PRU 7.4.159

For the purposes of PRU 7.4.158 R, smoothing costs are defined as the present value of the difference between projected claims and the projected with-profits benefit reserve after enhancements (PRU 7.4.141 R), other than payouts on guarantees (PRU 7.4.148 R).

31/12/2004

PRU 7.4.160

Subject to PRU 7.4.188 R, the future costs of smoothing can be negative.

31/12/2004

PRU 7.4.161

PRU 7.4.169 R to PRU 7.4.186 G contain further rules and guidance on the valuation of the future costs of smoothing.

31/12/2004

Financing costs

PRU 7.4.162

A firm must provide for future liabilities to repay financing costs of a with-profits fund where the firm expects to have to meet such liabilities and to the extent that these liabilities are not already provided for by amounts included in the fund's realistic current liabilities (PRU 7.4.190 R and PRU 7.4.191 R). The amount of the liabilities to repay financing costs must be assessed on a market-consistent basis.

31/12/2004

PRU 7.4.163

In PRU 7.4.162 R, financing costs refer to the future costs incurred by way of capital, interest and fees payable to the provider. A firm should make a realistic assessment of the requirement to repay such financing in its expected future circumstances (which may be worse than currently). Having taken account of its particular circumstances:

(1) where a firm has no liability to repay such financing, it should not include such repayment as a liability;
(2) where a firm has a reduced liability to repay such financing, it should include a reduced repayment as a liability.

31/12/2004

PRU 7.4.164

In PRU 7.4.162 R, financing includes reinsurance financing arrangements and analogous non-reinsurance financing arrangements, such as contingent loans, securitisations and any other arrangements giving rise to charges on future surplus arising.

31/12/2004

Other long-term insurance liabilities

PRU 7.4.165

A firm must provide for any other long-term insurance liabilities arising from or in connection with with-profits insurance contracts in a with-profits fund, to the extent that adequate provision has not been made in the with-profits benefits reserve or in any other part of the future policy related liabilities for that fund.

31/12/2004

PRU 7.4.166

Some examples of these other long-term insurance liabilities are:

(1) pension and other mis-selling reserves;
(2) provisions for tax; and
(3) provisions for future shareholder transfers.

31/12/2004

PRU 7.4.167

In determining the realistic liability for taxation firms should apply the general principles set out in PRU 7.4.105 R and the guidance given in PRU 7.4.107 G.

31/12/2004

PRU 7.4.168

PRU 7.4.105 R requires firms to provide for shareholder transfers out of the with-profits fund as a liability of the fund. The provision should be consistent with the methods and assumptions used in valuing the other realistic liabilities. So, for example, where the with-profits benefits reserve includes amounts that would be paid to policyholders through future bonuses, provision should also be made for future shareholder transfers associated with those bonuses.

31/12/2004

Valuing the costs of guarantees, options and smoothing

PRU 7.4.169

For the purposes of PRU 7.4.137 R (5), PRU 7.4.137 R (7) and PRU 7.4.137 R (8), a firm must calculate the costs of any guarantees, options and smoothing using one or more of the following three methods:

(1) a stochastic approach using a market-consistent asset model (PRU 7.4.170 R);
(2) using the market costs of hedging the guarantee or option;
(3) a series of deterministic projections with attributed probabilities.

31/12/2004

PRU 7.4.170

The market-consistent asset model in PRU 7.4.169 R (1):

(1) means a model that delivers prices for assets and liabilities that can be directly verified from the market; and
(2) must be calibrated to deliver market-consistent prices for those assets that reflect the nature and term of the with-profits insurance liabilities of the with-profits fund.

31/12/2004

PRU 7.4.171

Deterministic approaches will not usually capture the time value of the option generated by a guarantee. In order to calculate this value properly, firms are expected either to use market option values where these are readily available or to undertake a stochastic approach using a market-consistent asset model.

31/12/2004

PRU 7.4.172

The FSA considers stochastic modelling to be preferable for material groups or classes of with-profits insurance contracts unless it can be shown that more simplistic or alternative methods are both appropriate and sufficiently robust.

31/12/2004

PRU 7.4.173

Where the guarantee or option is relatively simple in nature, is capable of being hedged, and has a value unlikely to be affected by management actions (PRU 7.4.185 R) (for example, a guaranteed annuity rate option) then the cost of the guarantee or option would be the market cost of hedging the guarantee. Where that is generally the case but, in respect of a minor part of a portfolio, no market exists for hedging the option generated by the guarantee, a firm should take the value of the nearest equivalent benefit or right for which a market exists and record how it has adjusted the valuation to reflect the original option. Where the market value of the hedge is used firms should also make provisions for the credit risk arising from the hedge, both that arising from exposure to a counterparty and that arising from credit risk in the underlying instrument. The extent to which the guarantee or option is capable of being hedged depends on a firm's assumptions regarding future investment mix, persistency, annuitant mortality and take-up rates. While the FSA recognises that the hedge may not be perfectly matched to the underlying guarantee or option, a firm should ensure that hedge is reasonably well matched having regard to the sensitivity of the guarantee or option to the firm's choice of key assumptions.

31/12/2004

PRU 7.4.174

Where a firm has large cohorts of guarantees and uses stochastic or deterministic approaches, a firm should have regard to whether the cost of the guarantees determined under those approaches bears a reasonable relationship to the market cost of hedging those guarantees (where it exists).

31/12/2004

PRU 7.4.175

In determining the costs of smoothing, a firm should consider:

(1) the consistency of its assumptions (including the exercise of management discretion over bonus rates); and
(2) where targeted payouts currently exceed retrospective reserves in respect of those claims, the assumptions used in reducing the excess, if applicable,
having regard to the firm's PPFM and its regulatory duty to treat its customers fairly.

31/12/2004

Stochastic approach

PRU 7.4.176

For the purposes of PRU 7.4.169 R (1), a stochastic approach would consist of an appropriate market-consistent asset model for projections of asset prices and yields (such as equity prices, fixed interest yields and property yields), together with a dynamic model incorporating the corresponding value of liabilities and the impact of any foreseeable actions to be taken by management. Under the stochastic approach, the cost of the guarantee, option or smoothing would be equal to the average of these stochastic projections.

31/12/2004

PRU 7.4.177

In performing the projections of assets and liabilities under the stochastic approach in PRU 7.4.169 R (1), a firm should have regard to the aspects in (1) and (2).

(1) The projection term should be long enough to capture all material cash flows arising from the contract or groups of contracts being valued. If the projection term does not extend to the term of the last policy, the firm should check that the shorter projection term does not significantly affect the results.
(2) The number of projections should be sufficient to ensure a reasonable degree of convergence in the results, including the determination of the result of the risk capital margin. The firm should test the sensitivity of the results to the number of projections.

31/12/2004

PRU 7.4.178

The FSA considers a holistic approach to stochastic modelling to be preferable so as to value all items of costs together rather than using separate methods for different items of the realistic value of liabilities. This approach requires the projection of all material cash flows arising under the contract or group of contracts for each stochastic projection, rather than only those arising from the guarantee or option within the contract. The advantages of this approach are that it ensures greater consistency in the valuation of different components of the contract and explicitly takes into account the underlying hedges or risk mitigation between components of the contract or group of contracts being valued. Where a firm can use a stochastic approach to value simultaneously all components of the contract or group of contracts, the firm should adopt this approach where practical and feasible.

31/12/2004

PRU 7.4.179

Where a stochastic approach is used, a firm should make and retain a record under PRU 7.4.17 R of the nature of the asset model and of the assumptions used (including the volatility of asset values and any assumed correlations between asset classes or between asset classes and economic indicators, such as inflation).

31/12/2004

PRU 7.4.180

In calibrating asset models for the purposes of PRU 7.4.170 R, a firm should have regard to the aspects in (1), (2) and (3).

(1) Few (if any) asset models can replicate all the observable market values for a wide range of asset classes. A firm should calibrate its asset models to reflect the nature and term of the fund's liabilities giving rise to significant guarantee and option costs.
(2) A firm will need to apply judgement to determine suitable estimates of those parameters which cannot be implied from observable market prices (for example, long-term volatility). A firm should make and retain a record under PRU 7.4.17 R of the choice of parameters and the reasons for their use.
(3) A firm should calibrate the model to the current risk-free yield curve. Risk-free yields should be determined after allowing for credit and all other risks arising. Firms may have regard to any guidance from the actuarial profession on the calculation of the risk-free yield but should not assume a higher yield than suggested by any such guidance.

31/12/2004

Deterministic approach

PRU 7.4.181

For the purposes of the deterministic approach in PRU 7.4.169 R (3), a firm must calculate a series of deterministic projections of the values of assets and corresponding liabilities, where each deterministic projection corresponds to a possible economic scenario or outcome.

31/12/2004

PRU 7.4.182

A firm should determine a range of scenarios or outcomes appropriate to both valuing the costs of the guarantee, option or smoothing and the underlying asset mix, together with the associated probability of occurrence. These probabilities of occurrence should be weighted towards adverse scenarios to reflect market pricing for risk. The costs of the guarantee, option or smoothing should be equal to the expected cost based on a series of deterministic projections of the values of assets and corresponding liabilities. In using a series of deterministic projections, a firm should consider whether its approach provides a suitably robust estimate of the costs of the guarantee, option or smoothing.

31/12/2004

PRU 7.4.183

In performing the projections of assets and liabilities under the deterministic approach in PRU 7.4.169 R (3), a firm should have regard to the aspects in (1) and (2).

(1) The projection term should be long enough to capture all material cash flows arising from the contract or group of contracts being valued. If the projection term does not extend to the term of the last contract, the firm should check that the shorter projection term does not significantly affect the results.
(2) The series of deterministic projections should be numerous enough to capture a wide range of possible outcomes and take into account the probability of each outcome's likelihood. The costs will be understated if only relatively benign or limited economic scenarios are considered.

31/12/2004

PRU 7.4.184

Where a series of deterministic projections is used, a firm should make and retain a record under PRU 7.4.17 R of the range of projections and how the probabilities attributed to each projection or outcome were determined (including the period of reference for any relevant data on past experience).

31/12/2004

Management and policyholder actions

PRU 7.4.185

In calculating the costs of any guarantees, options or smoothing, a firm:

(1) may reflect its prospective management actions (within the meaning of PRU 7.4.53 R); and
(2) must reflect a realistic assessment of the policyholder actions (within the meaning of PRU 7.4.59 R);

in its projections of the value of assets and liabilities.

31/12/2004

PRU 7.4.186

For the purposes of PRU 7.4.185 R, the related guidance in PRU 7.4.54 G to PRU 7.4.57 G (management actions) and in PRU 7.4.60 G (policyholder actions) applies.

31/12/2004

Treatment of surplus on guarantees, options and smoothing

PRU 7.4.187

PRU 7.4.188 R applies to firms calculating the costs of guarantees, options and smoothing to be included in the future policy-related liabilities in accordance with PRU 7.4.137 R (5), PRU 7.4.137 R (7) and PRU 7.4.137 R (8).

31/12/2004

PRU 7.4.188

Where a firm accumulates past experience and deducts or is otherwise able to take credit for charges for guarantees or options or smoothing, the future costs of guarantees or options or smoothing (as appropriate) must not be less than the greater of:

(1) the prospective calculation of the future cost of guarantees (see PRU 7.4.148 R) or options (see PRU 7.4.156 G) or smoothing (see PRU 7.4.158 R) (as appropriate); and
(2) the sum of:

(a) the accumulated charges (after deduction of past costs) for guarantees or options or smoothing (as appropriate); and
(b) the prospective calculation of the future charges deducted for guarantees or options or smoothing (see PRU 7.4.144 R) (as appropriate).

31/12/2004

PRU 7.4.189

The extent to which the amount in PRU 7.4.188 R (2) exceeds the amount in PRU 7.4.188 R (1) will determine the surplus available to support actions that would be taken by the firm's management. The purpose of PRU 7.4.188 R is to ensure that any resulting surplus at the valuation date arising from the accumulation of charges less costs remains available to support foreseeable actions that would be taken by the firm's management. Any additional liability arising from PRU 7.4.188 R is added to the liabilities under PRU 7.4.137 R (5), PRU 7.4.137 R (7) and PRU 7.4.137 R (8), but has no impact on the adjustment for planned deductions for the costs of guarantees, options and smoothing (PRU 7.4.137 R (3) and PRU 7.4.144 R).

31/12/2004

Realistic current liabilities

PRU 7.4.190

For the purposes of PRU 7.4.40 R (3), the realistic current liabilities of a with-profits fund are equal to the sum of the following amounts:

(1) the firm's best estimate provision for those liabilities for which prudent provision is made in regulatory current liabilities (see PRU 7.4.30 R); and

(2) to the extent that amounts have not been provided in (1), any tax and any other costs arising either in respect of excess admissible assets (within the meaning of PRU 7.4.36 R) or on the recognition of future shareholder transfers.

31/12/2004

PRU 7.4.191

For the purpose of assessing the best estimate provision to be made under PRU 7.4.190 R (1) in respect of a defined benefit occupational pension scheme, a firm must use either its defined benefit liability or its deficit reduction amount, consistent with the firm's election under PRU 1.3.5BR (2).

21/04/2005

PRU 7.5

Equalisation provisions

01/10/2005

Application

PRU 7.5.1

PRU 7.5 applies to an insurer carrying on general insurance business 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 7.5.2

The scope of PRU 7.5.11 R to PRU 7.5.37 G (non-credit equalisation provisions) is not restricted to firms subject to the relevant EC directives. It applies, for example, to pure reinsurers.

31/12/2004

PRU 7.5.3

The requirements of this section apply to a firm on a solo basis.

31/12/2004

Purpose

PRU 7.5.4

This section sets out rules and guidance on the calculation of the amount of the equalisation provisions that are required to be maintained by firms that carry on non-credit insurance business or credit insurance business.

31/12/2004

PRU 7.5.5

Credit or non-credit equalisation provisions form part of the technical provisions that a firm is required to establish under PRU 7.2.12 R (1). They help to smooth fluctuations in loss ratios in future years for business where claims in any future year may be subject to significant deviation from recent or average claims experience, or where trends in experience may be subject to change. Such volatile claims experience might arise in the case, for example, of insurance against losses caused by major catastrophes such as hurricanes or earthquakes.

31/12/2004

PRU 7.5.6

In general terms, PRU 7.5 sets out rules and guidance as to:

(1) the circumstances in which a firm is required to maintain equalisation provisions;
(2) the methods to be used in calculating the amount of each provision;
(3) the geographical location of the business relevant to certain calculations for different types of firm - this is summarised in the Table in PRU 7.5.7 G.

31/12/2004

PRU 7.5.7

Table: Scope of insurance business to be included in calculations

Type Of Firm

Credit Equalisation Provision

Non Credit Equalisation Provision

Threshold in PRU 7.5.44 R

Provision in PRU 7.5.43 R

Threshold in PRU 7.5.18 R (2) and provision in PRU 7.5.17 R

UK insurer

World-wide

Pure reinsurer with head office outside United Kingdom

PRU 7.5.39 R to PRU 7.5.47 G do not apply

Pure reinsurer with head office in United Kingdom

PRU 7.5.39 R to PRU 7.5.47 G do not apply

World-wide

Non-EEA direct insurers

EEA-deposit insurer

Swiss general insurer

UK-deposit insurer

All EEA

World-wide

All other non-EEA direct insurers

World-wide

31/12/2004

PRU 7.5.8

The First Non-Life Directive (as amended) requires the calculation of credit equalisation provisions. Non-credit equalisation provisions are a domestic United Kingdom requirement. For insurance regulatory purposes under EC Directives, credit equalisation provisions are classified as liabilities.

31/12/2004

PRU 7.5.9

However, firms are permitted to include equalisation provisions within their financial resources when demonstrating compliance with non-Directive capital requirements. Hence equalisation provisions are deducted from the available capital resources of a firm for the purpose of meeting its minimum capital requirement for general insurance business; but, in the calculation of a firm's enhanced capital requirement for general insurance business under PRU 2.3.11 R, its equalisation provisions (if any) are added back to its capital resources.

31/12/2004

PRU 7.5.10

Under International Accounting Standards (IAS), which will apply to the financial statements of some insurers from 2005, there will be no requirement to treat equalisation provisions as liabilities in insurers' published financial statements. However, they will continue to be treated as liabilities for the purposes of demonstrating compliance with Directive capital requirements.

31/12/2004

Firms carrying on non-credit insurance business

PRU 7.5.11

(1) PRU 7.5.11 R to PRU 7.5.37 G apply to any firm, other than an assessable mutual, which carries on the business of effecting or carrying out general insurance contracts falling within any description in column 2 in Table PRU 7.5.12 R ("non-credit insurance business").
(2) A firm falling within (1) must classify all of its non-credit insurance business into separate insurance business groupings, as specified in Table PRU 7.5.12 R.

31/12/2004

PRU 7.5.12

Table : Groupings of non-credit insurance business

Insurance Business Grouping

General Insurance Contracts

Contracts of insurance which fall within general insurance business classes 4, 8 or 9, other than:

(a)

contracts of insurance under non-proportional reinsurance treaties; and

(b)

contracts of insurance against nuclear risks.

Contracts of insurance which fall within general insurance business class 16(a) , other than:

(a)

contracts of insurance under non-proportional reinsurance treaties; and

(b)

contracts of insurance against nuclear risks.

Contracts of insurance which fall within general insurance business classes 5, 6, 11 or 12, other than:

(a)

contracts of insurance against nuclear risks; and

(b)

reinsurance contracts corresponding to contracts in (a).

Contracts of insurance against nuclear risks.

Contracts of insurance under non-proportional reinsurance treaties and which fall within general insurance business classes 4, 8, 9 or 16(a) other than contracts of insurance against nuclear risks.

31/12/2004

PRU 7.5.13

For the purposes of PRU 7.5.11 R to PRU 7.5.37 G, a firm with its head office in the United Kingdom must take account of non-credit insurance business carried on by it world-wide.

31/12/2004

PRU 7.5.14

For the purposes of PRU 7.5.11 R to PRU 7.5.37 G, a firm with its head office outside the United Kingdom need only take account of non-credit insurance business carried on by it from a branch in the United Kingdom.

31/12/2004

PRU 7.5.15

The insurers affected by PRU 7.5.11 R include pure reinsurers, UK-deposit insurers, EEA-deposit insurer, and Swiss general insurers.

31/12/2004

PRU 7.5.16

For insurers (including pure reinsurers) with a head office in the United Kingdom, the calculations must be made in respect of world-wide business.

31/12/2004

Requirement to maintain non-credit equalisation provision

PRU 7.5.17

In respect of each financial year, a firm must, unless PRU 7.5.18 R applies:

(1) calculate the amount of its non-credit equalisation provision as at the end of that year in accordance with PRU 7.5.20 R; and
(2) maintain a non-credit equalisation provision calculated in accordance with PRU 7.5.20 R for the following financial year.

31/12/2004

PRU 7.5.18

(1) PRU 7.5.17 R does not apply to any firm in respect of any financial year if, as at the end of that year:

(a) no non-credit equalisation provision has been brought forward from the preceding financial year; and
(b) the amount of the annualised net written premiums for all the non-credit insurance business carried on by it in the financial year is less than the threshold amount.

(2) The threshold amount in respect of any financial year is the higher of:

(a) 1,500,000 Euro; and
(b) 4% of net written premiums in that financial year in respect of all its general insurance business, if this amount is less than 2,500,000 Euro.

31/12/2004

PRU 7.5.19

For non-EEA insurers, the calculation of the threshold amount in PRU 7.5.18 R (2) is limited by PRU 7.5.14 R to the business of the firm carried on in the United Kingdom. Such a firm may do little UK non-credit insurance business, and so would not be required to set up a non-credit equalisation provision under PRU 7.5, but may do significant business outside the United Kingdom characterised by high-impact, low-frequency claims. Such a firm is required by PRU 7.6.41 R to hold adequate world-wide financial resources to avoid internal-contagion strain on the branch in the United Kingdom. In determining the adequacy of its financial resources, the firm should undertake stress and scenario testing of its underwriting and other risks as set out in PRU 1.2.

31/12/2004

Calculating the amount of the provision

PRU 7.5.20

(1) Unless PRU 7.5.22 R applies, the amount of a firm's non-credit equalisation provision as at the end of a financial year is the higher of:

(a) zero; and
(b) whichever is the lower of:

(i) the aggregate of the amounts of the maximum provision for each insurance business grouping as at the end of that financial year; and
(ii) the sum of A and B.

(2) For the purposes of (1)(b)(ii):

(a) A is the amount of the non-credit equalisation provision, if any, brought forward from the financial year immediately preceding that in respect of which the calculation is being performed; and
(b) B is:

(i) the aggregate of the amounts of the provisional transfers-in for each insurance business grouping; minus
(ii) the aggregate of the amounts of the provisional transfers-out for each insurance business grouping.

(3) For any insurance business grouping:

(a) the amount of the maximum provision in (1)(b)(i) is to be determined in accordance with PRU 7.5.24 R;
(b) the amount of the provisional transfers-in in (2)(b)(i) is to be determined in accordance with PRU 7.5.26 R; and
(c) the amount of the provisional transfers-out in (2)(b)(ii) is to be determined in accordance with PRU 7.5.29 R.

31/12/2004

PRU 7.5.21

If provisional transfers-out are in excess of provisional transfers-in, the non-credit equalisation provision as calculated in accordance with PRU 7.5.20 R in respect of a particular financial year may be less than that calculated for the preceding financial year although, by virtue of PRU 7.5.20 R (1)(a), it cannot be negative.

31/12/2004

PRU 7.5.22

(1) The amount of a firm's non-credit equalisation provision as at the end of a financial year is zero if:

(a) as at the end of that year, the firm meets either of the conditions specified in (2) and (3); and
(b) the annualised net written premiums for all the non-credit insurance business carried on by the firm in that year are less than the threshold amount.

(2) The first condition is that the firm carried on non-credit insurance business in the first financial year of the relevant period and, for each of any two or more financial years of that period, the annualised net written premiums for business of that description were less than the threshold amount.
(3) The second condition is that the firm did not carry on non-credit insurance business in the first financial year of the relevant period and the average of the annualised net written premiums for business of that description carried on by the firm in each financial year of the relevant period was less than the threshold amount.
(4) For the purposes of this rule:

(a) the threshold amount is the amount determined in accordance with PRU 7.5.18 R (2): and
(b) the relevant period is the period of four financial years ending immediately before the beginning of the financial year in (1).

31/12/2004

PRU 7.5.23

If PRU 7.5.22 R applies, a firm may need to make sufficient transfers from its non-credit equalisation provision to bring the non-credit equalisation provision for that financial year to zero.

31/12/2004

The calculation: the maximum provision

PRU 7.5.24

(1) For the purposes of the calculation required by PRU 7.5.20 R, the amount of the maximum provision for any insurance business grouping is to be determined in accordance with (2) to (5).
(2) Unless (4) applies, the amount of the maximum provision for the grouping, as at the end of a financial year, is the amount determined by multiplying X and Y.
(3) For the purposes of (2):

(a) X is the percentage specified in Table PRU 7.5.25 R in relation to the grouping; and
(b) Y is the average of the amount of the annualised net written premiums for non-credit insurance business in the grouping carried on by the firm in each financial year of the relevant period.

(4) Where Y is a negative amount, the maximum provision for that insurance business grouping is zero.
(5) For the purposes of (3)(b), the relevant period is the five-year period comprising:

(a) the financial year in (2); and
(b) the previous four financial years.

31/12/2004

PRU 7.5.25

Table : Calculation of maximum provision for any insurance business grouping

Insurance Business Grouping

Percentage of average annualised net written premiums

600

31/12/2004

The calculation: provisional transfers-in

PRU 7.5.26

(1) For the purposes of the calculation required by PRU 7.5.20 R, the amount of the provisional transfers-in for any insurance business grouping is to be determined in accordance with (2).
(2) The amount of the provisional transfers-in for the grouping, as at the end of a financial year, is the amount determined by multiplying X and Y.
(3) For the purposes of (2):

(a) X is the percentage specified in Table PRU 7.5.27 R in relation to the grouping; and
(b) Y is the amount of the net written premiums for non-credit insurance business in the grouping that was carried on by the firm in the financial year in (2), including adjustments in respect of previous financial years.

31/12/2004

PRU 7.5.27

Table : Provisional transfers-in for any insurance business grouping

Insurance Business Grouping

Percentage of net written premiums

31/12/2004

PRU 7.5.28

Since each insurance business grouping should be assessed individually, negative net written premiums in relation to any insurance business grouping should be transferred in to the non-credit equalisation provision.

31/12/2004

The calculation: provisional transfers-out

PRU 7.5.29

(1) For the purposes of the calculation required by PRU 7.5.20 R, the amount of the provisional transfers-out for any insurance business grouping is to be determined in accordance with (2).
(2) The amount of the provisional transfers-out for the grouping, as at the end of a financial year, is the lower of:

(a) the amount of the maximum provision for the grouping under PRU 7.5.24 R for that financial year; and
(b) the abnormal loss for the grouping under PRU 7.5.30 R for that financial year.

31/12/2004

PRU 7.5.30

For each insurance business grouping, the abnormal loss as at the end of a financial year in relation to which an equalisation provision is calculated is:

(1) (for business within the insurance business grouping accounted for on an accident year basis) the amount, if any, by which the amount of net claims incurred exceeds the greater of:

(a) zero; and
(b) the percentage of net earned premiums in that financial year specified in the Table in PRU 7.5.31 R; or

(2) (for business within the insurance business grouping accounted for on an underwriting year basis) the amount, if any, by which the amount of net claims paid (plus adjustment for change in net technical provisions, other than any change in provisions for claims handling expenses or equalisation) exceeds the greater of:

(a) zero; and
(b) the percentage of net written premiums in that financial year specified in the Table in PRU 7.5.31 R.

31/12/2004

PRU 7.5.31

Table : Abnormal loss for any insurance business grouping

Insurance business grouping

Percentage of net written premiums

72.5

100

31/12/2004

Transfers of business from the firm

PRU 7.5.32

(1) This rule applies to modify the application of PRU 7.5.24 R and PRU 7.5.26 R in any case where a firm has transferred to another undertaking any rights and obligations under general insurance contracts falling within any insurance business grouping.
(2) As at the end of the financial year in which the transfer takes place, net written premiums in respect of the transferred contracts in any grouping must be deducted from total net written premiums for that grouping before calculating the maximum provision under PRU 7.5.24 R or provisional transfers-in under PRU 7.5.26 R.

31/12/2004

PRU 7.5.33

If all the rights and obligations of a firm in relation to non-credit insurance business in any insurance business grouping have been transferred, the maximum provision for the grouping under PRU 7.5.24 R is zero.

31/12/2004

Transfers of business to the firm

PRU 7.5.34

(1) This rule applies to modify the application of PRU 7.5.24 R, PRU 7.5.26 R and PRU 7.5.29 R in any case where another undertaking has transferred to a firm any rights and obligations under general insurance contracts falling within any insurance business grouping.
(2) As at the end of the financial year in which the transfer takes place a sum equal to that part of the consideration for the transfer that relates to business in an insurance business grouping must be:

(a) excluded from net premiums (written or earned) before performing the calculations required by PRU 7.5.24 R (maximum provision) and PRU 7.5.26 R (provisional transfers in);
(b) included in net premiums (written or earned) before performing the calculation required by PRU 7.5.30 R (abnormal loss); and
(c) excluded from net claims (paid or incurred) before performing the calculation required by PRU 7.5.30 R (abnormal loss).

31/12/2004

PRU 7.5.35

For the purposes of PRU 7.5.34 R, the consideration payable should be apportioned between insurance business groupings according to the groupings within which the general insurance contracts which are the subject of the acquisition fall. In appropriate cases, apportionment may reflect the split of liabilities acquired, including unearned premium.

31/12/2004

PRU 7.5.36

Where business is accounted for on an accounting year basis, in any year following the transfer, net earned premiums must include an appropriate amount in respect of the transfer.

31/12/2004

PRU 7.5.37

PRU 7.5.32 R to PRU 7.5.34 R apply to transfers by way of transfer under Part VII of the Act and by novation.

31/12/2004

Firms carrying on credit insurance business

PRU 7.5.38

PRU 7.5.39 R to PRU 7.5.47 G apply to:

(1) any UK insurer; and
(2) any non-EEA direct insurer;

which carries on the business of effecting or carrying out general insurance contracts falling within general insurance business class 14 (which business, excluding contracts of reinsurance, is referred to in PRU 7.5 as "credit insurance business").

31/12/2004

PRU 7.5.39

For the purposes of PRU 7.5.43 R, a UK insurer must take account of the credit insurance business carried on by it world-wide.

31/12/2004

PRU 7.5.40

(1) For the purposes of PRU 7.5.43 R:

(a) a Swiss general insurer or an EEA-deposit insurer must take account of the credit insurance business carried on by it in the United Kingdom; and
(b) a UK-deposit insurer must take account of the credit insurance business carried on by it world-wide.

(2) For the purposes of PRU 7.5.44 R:

(a) a UK-deposit insurer need only take account of the credit insurance business carried on by it in all EEA States, taken together; and
(b) any other description of non-EEA direct insurer (including an EEA-deposit insurer and a Swiss general insurer) need only take account of the credit insurance business carried on by it in the United Kingdom.

31/12/2004

PRU 7.5.41

For UK insurers the calculations must be made in respect of world-wide business.

31/12/2004

PRU 7.5.42

The requirements of PRU 7.5.39 R and PRU 7.5.40 R are summarised in the table in PRU 7.5.7 G.

31/12/2004

Requirement to maintain credit equalisation provision

PRU 7.5.43

In respect of each financial year, a UK insurer or a non-EEA direct insurer must, unless PRU 7.5.44 R applies:

(1) calculate the amount of its credit equalisation provision as at the end of that year in accordance with PRU 7.5.45 R; and
(2) maintain a credit equalisation provision calculated in accordance with PRU 7.5.45 R for the following financial year.

31/12/2004

PRU 7.5.44

PRU 7.5.43 R does not apply to any UK insurer or a non-EEA direct insurer in respect of any financial year if, as at the end of that year, the annualised net written premiums for its credit insurance business are less than 4% of annualised net written premiums in that financial year in respect of all its general insurance business, if this amount is less than 2,500,000 Euro.

31/12/2004

Calculating the amount of the provision

PRU 7.5.45

(1) The amount of a UK insurer's, or a non-EEA direct insurer's, credit equalisation provision as at the end of a financial year ("financial year A") is the higher of:

(a) zero; and
(b) whichever is the lower of:

(i) 150% of the highest amount of net written premiums for credit insurance business carried on by the firm in financial year A or in any of the previous four financial years; and
(ii) the amount of the credit equalisation provision brought forward from the preceding financial year, after making either of the adjustments in (2).

(2) The adjustments are:

(a) the deduction of the amount of any technical deficit arising in financial year A; or
(b) the addition of the lower of:

(i) 75% of the amount of any technical surplus arising in financial year A; and
(ii) 12% of the amount of the net written premiums for credit insurance business carried on by the firm in financial year A.

(3) For the purposes of (2) the amount of technical deficit or technical surplus is to be determined in accordance with PRU 7.5.46 R.

31/12/2004

PRU 7.5.46

For the purposes of the adjustments in PRU 7.5.45 R (2), technical surplus (or technical deficit) in respect of credit insurance business is the amount by which the aggregate of net earned premiums and other technical income exceeds (or falls short of) the sum of net claims incurred, claims management costs and any technical charges.

31/12/2004

PRU 7.5.47

The calculation of technical surplus or technical deficit should be made before tax and before any transfer to or from the credit equalisation provision. Investment income should not be included in these calculations.

31/12/2004

Euro conversion

PRU 7.5.48

For the purposes of PRU 7.5, 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.

31/12/2004

PRU 7.6

Internal-contagion risk

01/10/2005

Application

PRU 7.6.1

PRU 7.6 applies to an insurer.

31/12/2004

PRU 7.6.2

PRU 7.6 does not apply, to the extent stated, to any insurer in (1) to (4):

(1) none of the provisions apply to non-directive friendly societies;
(2) none of the provisions, apart from PRU 7.6.33 R (payment of financial penalties) apply to firms which qualify for authorisation under Schedule 3 or 4 of the Act;
(3) PRU 7.6.33 R (payment of financial penalties) does not apply to mutuals;
(4) PRU 7.6.41 R to PRU 7.6.57 R(UK branches of certain non-EEA insurers) do not apply to:

(a) UK insurers; or
(b) non-EEA insurers whose insurance business in the United Kingdom is restricted to reinsurance; or
(c) EEA-deposit insurers; or
(d) Swiss general insurers.

31/12/2005

PRU 7.6.3

The scope of application of PRU 7.6 is not restricted to firms that are subject to the relevant EC directives. It applies, for example, to pure reinsurers.

31/12/2004

PRU 7.6.4

In its application to a firm with its head office in the United Kingdom, this section applies to the whole of the firm's business carried on world-wide.

31/12/2004

PRU 7.6.5

In the application of this section to activities carried on by a non-EEA insurer:

(1) PRU 7.6.13 R to PRU 7.6.15 G and PRU 7.6.41 R apply in relation to the whole of its business carried on world-wide;
(2) all other provisions of this section apply only in relation to:

(a) in the case of any UK-deposit insurer, activities carried on from branches in any EEA State; and
(b) in any other case, activities carried on from a branch in the United Kingdom.

31/12/2004

PRU 7.6.6

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

31/12/2004

PRU 7.6.7

The requirements of this section apply to a firm on a solo basis.

31/12/2004

Purpose

PRU 7.6.8

This section sets out requirements for a firm relating to 'internal-contagion risk'. This is the risk that losses or liabilities from one activity might deplete or divert financial resources held to meet liabilities from another activity. It arises where the two activities are carried on within the same firm. It may also arise from the combination of activities within the same group, but this aspect of internal-contagion risk falls outside the scope of this section. Requirements relevant to group contagion risk are set out in PRU 8.

31/12/2004

PRU 7.6.9

Internal-contagion risk includes in particular the risk that arises where a firm carries on:

(1) both insurance and non-insurance activities; or
(2) two or more different types of insurance activity; or
(3) insurance activities from offices or branches located in both the United Kingdom and overseas.

31/12/2004

PRU 7.6.10

This section requires firms to limit non-insurance activities to those that directly arise from their insurance business, e.g. investing assets, employing insurance staff etc. It also requires that an adequate provision be established for non-insurance liabilities.

31/12/2004

PRU 7.6.11

This section also sets out requirements for the separation of different types of insurance activity. However, in most circumstances the combination of different types of insurance activity within the same firm is a source of strength. Adequate pooling and diversification of insurance risk is fundamental to sound business practice. The requirements, therefore, only apply in two specific cases where without adequate protection the combination might operate to the detriment of policyholders. They apply where a firm carries on both:

(1) general insurance business and long-term insurance business;
(2) linked and non-linked insurance business.

31/12/2004

PRU 7.6.12

Finally, the section sets out requirements to protect policyholders of branches of non-EEA firms where these are supervised by the FSA. These apply only to a non-EEA firm that has established a branch in the United Kingdom.

31/12/2004

Restriction of business to insurance

PRU 7.6.13

(1) A firm must not carry on any commercial business other than insurance business and activities directly arising from that business.
(2) (1) does not prevent a friendly society which was on 15 March 1979 carrying on long-term insurance business from continuing to carry on savings business.

31/12/2004

Financial limitation of non-insurance activities

PRU 7.6.14

A firm must limit, manage and control its non-insurance activities so that there is no significant risk arising from those activities that it may be unable to meet its liabilities as they fall due.

31/12/2004

PRU 7.6.15

For the purpose of PRU 7.6.14 R a firm should consider how the financial impact of non-insurance activities might diverge from expectations. However, it need only take into account unexpected variations in amount and timing in so far as they are reasonably possible and may take into account effective mitigating factors.

31/12/2004

Requirements: long-term insurance business

PRU 7.6.16

PRU 7.6.18 R, PRU 7.6.21 R, PRU 7.6.30 R and PRU 7.6.31 R require a firm to identify the assets attributable to the receipts of the long-term insurance business, called long-term insurance assets, and only to apply those assets for the purpose of that business. This has the effect of prohibiting a composite firm from using long-term insurance assets to meet general insurance liabilities. It also keeps long-term insurance assets separate from shareholder funds.

31/12/2004

Permissions not to include both types of insurance

PRU 7.6.17

Under section 31 of the Act, a firm may not carry on a regulated activity unless it has permission to do so (or is exempt in relation to the particular activity). Both general insurance business and long-term insurance business are regulated activities and permission will extend to the effecting or carrying out of one or more particular classes of contracts of insurance. A firm's permission can be varied so as to add other classes. It is FSA policy, in compliance with EC directives on insurance, not to grant or vary permission if that would allow a firm to engage in both general insurance business and long-term insurance business. This does not apply where a firm's permission is restricted to reinsurance. It also does not apply where a firm's permission extends to effecting or carrying out life and annuity contracts of insurance. This will automatically include permission to effect or carry out accident contracts of insurance or sickness contracts of insurance on an ancillary or supplementary basis (see article 2(1) of the Consolidated Life Directive).

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Separately identify and maintain long term insurance assets

PRU 7.6.18

A firm carrying on long-term insurance business must identify the assets relating to its long-term insurance business which it is required to hold by virtue of PRU 7.2.20 R or PRU 7.2.21 R .

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PRU 7.6.19

PRU 7.2.16 R requires a firm to establish adequate technical provisions for its long-term insurance contracts. PRU 7.2.20 R requires a firm to hold admissible assets of a value at least equal to the amount of the technical provisions and its other long-term insurance liabilities. PRU 7.2.21 R ensures that a composite firm identifies separate admissible assets with a value at least equal to the technical provisions for long-term insurance business and its other long-term insurance liabilities as well as holding other admissible assets of a value at least equal to the amount of its technical provisions for general insurance business and its other general insurance liabilities. The overall impact of these provisions in PRU 7.2, and of PRU 7.6.18 R, is that any firm writing long-term insurance business must identify separately admissible assets of a value at least equal to the amount of its long-term insurance business technical provisions and its other long-term insurance liabilities.

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PRU 7.6.20

PRU 7.6.18 R does not prohibit a firm from identifying other assets as being available to meet the liabilities of its long-term insurance business. It may transfer such other assets to a long-term insurance fund (see PRU 7.6.21 R and PRU 7.6.22 R ) and the transfer will take effect when it is recorded in the firm's accounting records (see PRU 7.6.23 R). After the transfer takes effect, a firm may not transfer the assets out of a long-term insurance fund except where they represent an established surplus (see PRU 7.6.27 R).

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PRU 7.6.21

(1) A firm's long-term insurance assets are the items in (2), adjusted to take account of:

(a) outgo in respect of the firm's long-term insurance business; and
(b) any transfers made in accordance with PRU 7.6.27 R.

(2) The items are:

(a) the assets identified under PRU 7.6.18 R (including assets into which those assets have been converted);
(b) any other assets identified by the firm as being available to cover its long-term insurance liabilities;
(c) premiums and other receivables in respect of long-term insurance contracts;
(d) other receipts of the long-term insurance business; and
(e) all income and capital receipts in respect of the items in (2).

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PRU 7.6.22

(1) Unless (2) applies, all the long-term insurance assets of the firm constitute its long-term insurance fund.
(2) Where a firm identifies particular long-term insurance assets in connection with different parts of its long-term insurance business, the assets identified in relation to each such part constitute separate long-term insurance funds of the firm.

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PRU 7.6.23

A firm must maintain a separate accounting record in respect of each of its long-term insurance funds (including any with-profits fund).

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PRU 7.6.24

Firms must ensure that long-term insurance assets are separately identified and allocated to a long-term insurance fund at all times. Assets in external accounts, for example at banks, custodians, or brokers should be segregated in the firm's books and records into separate accounts for long-term insurance business and general insurance business. Where a firm has more than one long-term insurance fund, a separate accounting record must be maintained for each fund. Accounting records should clearly document the allocation.

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PRU 7.6.25

Where the surplus arising from business is shared between policyholders and shareholders in different ways for different blocks of business, it may be necessary to maintain a separate fund to ensure that policyholders are, and will be, treated fairly. For example, if a proprietary company writes some business on a with-profits basis, this should be written in a with-profits fund separate from any business where the surplus arising from that business is wholly owned by shareholders.

31/12/2004

PRU 7.6.26

Where a firm merges separate funds for different types of business, it will need to ensure that the merger will not result in policyholders being treated unfairly. When considering merging the funds, the firm should consider the impact on its PPFM (see COB 6.10) and on its obligations to notify the FSA (see SUP 15.3). In particular, a firm would need to consider how any inherited estate would be managed and how the fund would be run in future, such that policyholders are treated fairly.

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PRU 7.6.27

A firm may not transfer assets out of a long-term insurance fund unless:

(1) the assets represent an established surplus; and
(2) no more than three months have passed since the determination of that surplus.

31/12/2004

PRU 7.6.28

As a result of PRU 7.6.27 R (2), an actuarial investigation undertaken to determine an established surplus remains in-date for three months from the date as at which the determination of the surplus was made. However, even where the investigation is still in-date, the firm should not make the transfer unless there is sufficient surplus at the time of the transfer to allow it to be made without breach of PRU 7.2.20 R or PRU 7.2.21 R.

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PRU 7.6.29

PRU 7.2.27 R and PRU 7.2.28 R provide further constraints on the transfer of assets out of a with-profits fund. PRU 7.2.27 R requires a firm to have admissible assets in each of its with-profits funds to cover the technical provisions and other long-term insurance liabilities relating to all the business in that fund. PRU 7.2.28 R requires a realistic basis life firm to ensure that the realistic value of assets for each of its with-profits funds is at least equal to the realistic value of liabilities of that fund.

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Exclusive use of long-term insurance assets

PRU 7.6.30

(1) A firm must apply a long-term insurance asset only for the purposes of its long-term insurance business.
(2) For the purpose of (1), applying an asset includes coming under any obligation (even if only contingently) to apply that asset.

31/12/2004

PRU 7.6.31

A firm must not agree to, or allow, any mortgage or charge on its long-term insurance assets other than in respect of a long-term insurance liability.

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PRU 7.6.32

The purposes of the long-term insurance business include the payment of claims, expenses and liabilities arising from that business, the acquisition of lawful access to fixed assets to be used in that business and the investment of assets. The payment of liabilities may include repaying a loan but only where that loan was incurred for the purpose of the long-term insurance business. The purchase or investment of assets may include an exchange at fair market value of assets (including money) between the long-term insurance fund and other assets of the firm. A firm may also lend securities held in a long-term insurance fund under a stock lending transaction or transfer assets as collateral for a stock lending transaction where the firm is the borrower, where such lending or transfer is for the benefit of the long-term insurance business.

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Payment of financial penalties

PRU 7.6.33

If the FSA imposes a financial penalty on a long-term insurer, the firm must not pay that financial penalty from a long-term insurance fund.

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PRU 7.6.34

PRU 7.6.2 R states that this provision applies to all firms, except mutuals, and includes firms qualifying for authorisation under Schedule 3 or 4 to the Act.

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Requirements: property-linked funds

PRU 7.6.35

PRU 4.2.57 R requires a firm to cover, as closely as possible, its property-linked liabilities by the property to which those liabilities are linked. In order to comply with this rule, a firm should identify the assets it holds to cover property-linked liabilities and should not apply those assets (as long as they are needed to cover the property-linked liabilities) for any purpose other than to meet those liabilities.

31/12/2004

PRU 7.6.36

A firm must select, allocate and manage the assets to which its property-linked liabilities are linked taking into account:

(1) the firm's contractual obligations to holders of property-linked policies; and
(2) its regulatory duty to treat customers fairly, including in the way it makes discretionary decisions as to how it selects, allocates and manages assets.

31/12/2004

PRU 7.6.37

Property-linked liabilities may be linked either to specified assets (with no contractual discretion given to the firm as to the choice of assets) or to assets of a specified kind where the selection of the actual assets is left to the firm.

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Requirements: UK branches of certain non-EEA firms

PRU 7.6.38

The purpose of the rules and guidance set out in PRU 7.6.38 G to PRU 7.6.57 R is to protect against the risk that the financial resources required in respect of the activities of the United Kingdom (or EEA) branch(es) might be depleted by the other activities of the non-EEA direct insurer.

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PRU 7.6.39

By virtue of PRU 7.6.2 R (4), the rules in PRU 7.6.41 R to PRU 7.6.57 R apply to non-EEA direct insurers except for Swiss general insurers and EEA-deposit insurers. Responsibility for determining the adequacy of the world-wide financial resources of Swiss general insurers or EEA-deposit insurers rests exclusively with the Swiss authorities or the authorities in the EEA state (other than the United Kingdom) in which the deposit was made.

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PRU 7.6.40

(1) PRU 7.6.41 R requires a non-EEA direct insurer to hold adequate world-wide resources to meet the needs of the world-wide business without the need to rely on UK or EEA branch assets other than to meet branch liabilities.
(2) PRU 7.6.42 R to PRU 7.6.47 R require non-EEA direct insurers to calculate a local MCR and to hold assets representing that requirement in the EEA or the United Kingdom.
(3) PRU 7.6.48 R to PRU 7.6.52 R require non-EEA direct insurers to hold a minimum level of assets in the United Kingdom or EEA.
(4) PRU 7.6.54 R requires the deposit of a minimum level of assets in the United Kingdom.
(5) PRU 7.6.56 R and PRU 7.6.57 R require non-EEA direct insurers to keep adequate accounting records in the United Kingdom.

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Worldwide financial resources

PRU 7.6.41

(1) A non-EEA direct insurer must maintain adequate worldwide financial resources, to ensure that there is no significant risk that its liabilities cannot be met as they fall due.
(2) For the purpose of (1):

(a) a UK-deposit insurer must not rely upon the assets held under PRU 7.2.20 R as available to meet liabilities other than those arising from the activities of its branches in EEA States;
(b) other non-EEA direct insurers to whom (1) applies must not rely upon the assets held under PRU 7.2.20 R as available to meet liabilities other than those arising from the activities of any UK branch.

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UK or EEA MCR to be covered by admissible assets

PRU 7.6.42

A non-EEA direct insurer must:

(1) calculate a UK or EEA MCR in accordance with PRU 7.6.44 R to PRU 7.6.47 R; and
(2) hold admissible assets (in addition to those required under PRU 7.2.20 R) to represent its UK or EEA MCR calculated under (1).

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PRU 7.6.43

The assets held under PRU 7.6.42 R (2) must be identified and valued as if the non-EEA direct insurer was a firm with its head office in the United Kingdom.

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PRU 7.6.44

For the purposes of PRU 7.6.42 R, a non-EEA direct insurer (except a UK-deposit insurer) must calculate a UK MCR:

(1) for long-term insurance business, in accordance with PRU 7.2.81 R to PRU 7.2.91 R but only in relation to business carried on by the firm in the United Kingdom;
(2) for general insurance business, in accordance with PRU 7.2.45 R to PRU 7.2.72 R but only in relation to business carried on by the firm in the United Kingdom.

31/12/2004

PRU 7.6.45

For a composite firm, the UK MCR is the sum of the amounts arrived at under PRU 7.6.44 R (1) and PRU 7.6.44 R (2).

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PRU 7.6.46

For the purposes of PRU 7.6.42 R, a UK-deposit insurer must calculate an EEA MCR:

(1) for long-term insurance business, in accordance with PRU 7.2.81 R to PRU 7.2.91 R but only in relation to business carried on by the firm in all EEA States, taken together;
(2) for general insurance business, in accordance with PRU 7.2.45 R to PRU 7.2.72 R but only in relation to business carried on by the firm in all EEA States, taken together.

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PRU 7.6.47

For a composite firm, the EEA MCR is the sum of the amounts arrived at under PRU 7.6.46 R (1) and PRU 7.6.46 R (2).

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Localisation of assets

PRU 7.6.48

A non-EEA direct insurer (except a UK-deposit insurer) must hold:

(1) admissible assets which are required to cover its technical provisions in accordance with PRU 7.2.20 R (1) or PRU 7.2.21 R (1)(a) and (2)(a); and
(2) other admissible assets not required to cover property-linked liabilities or index-linked liabilities in accordance with PRU 4.2.57 R or PRU 4.2.58 R which represent its UK MCR as calculated in accordance with PRU 7.6.44 R;

as follows:

(a) (where the assets cover the technical provisions and the guarantee fund) in the United Kingdom;
(b) (where the assets represent the amount of the UK MCR in excess of the guarantee fund) in any EEA State.

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PRU 7.6.49

A UK-deposit insurer must hold:

(1) admissible assets which are required to cover its technical provisions in accordance with PRU 7.2.20 R (1) or PRU 7.2.21 R (1)(a)and (2)(a); and
(2) other admissible assets not required to cover property-linked liabilities or index-linked liabilities in accordance with PRU 4.2.57 R or PRU 4.2.58 R which represent its EEA MCR as calculated in accordance with PRU 7.6.46 R;

as follows:

(a) (where the assets cover the technical provisions and the guarantee fund) within the EEA states where the firm carries on insurance business;
(b) (where the assets represent the amount of the EEA MCR in excess of the guarantee fund) in any EEA State.

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PRU 7.6.50

PRU 7.6.48 R and PRU 7.6.49 R do not apply to assets covering technical provisions which are debts owed by reinsurers.

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PRU 7.6.51

The admissible assets in excess of the technical provisions and UK or EEA MCR may be held outside the EEA.

31/12/2004

PRU 7.6.52

For the purpose of PRU 7.6.48 R and PRU 7.6.49 R:

(1) a tangible asset is to be treated as held in the country or territory where it is situated;
(2) an admissible asset consisting of a claim against a debtor is to be regarded as held in any country or territory where it can be enforced by legal action;
(3) a listed security is to be treated as held in any country or territory where there is a regulated market in which the security is dealt; and
(4) a security which is not a listed security is to be treated as held in the country or territory in which the issuer has its head office.

31/12/2004

PRU 7.6.53

PRU 4.2.53 R to PRU 4.2.55 R (currency matching of assets and liabilities) apply to the assets held to match insurance liabilities calculated under PRU 7.2.12 R or PRU 7.2.16 R.

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Deposit of assets as security

PRU 7.6.54

A non-EEA direct insurer must keep assets of a value at least equal to one quarter of the base capital resources requirement on deposit in the United Kingdom with a BCD credit institution.

31/12/2005

PRU 7.6.55

The assets deposited as security may count towards the assets required under PRU 7.6.48 R and PRU 7.6.49 R. If, after the deposit is made, the value of the deposited assets falls below one quarter of the base capital resources requirement, the firm should deposit further admissible assets in order to comply with PRU 7.6.48 R and PRU 7.6.49 R. Deposited assets may be exchanged for other admissible assets and excess assets may be withdrawn, provided that the exchange or deposit does not cause a breach of PRU 7.6.48 R or PRU 7.6.49 R.

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Branch accounting records in the United Kingdom

PRU 7.6.56

A non-EEA direct insurer must maintain at a place of business in the United Kingdom adequate records relating to:

(1) the activities carried on from its United Kingdom branch; and
(2) if it is an EEA-deposit insurer, the activities carried on from the branches in other EEA States.

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PRU 7.6.57

The records maintained as required by PRU 7.6.56 R must include a record of:

(1) the income, expenditure and liabilities arising from activities of the branch or branches; and
(2) the assets identified under PRU 7.2.20 R as available to meet those liabilities.

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PRU 7 Annex 1G

PRU 7.3 (Mathematical reserves) and PRU 7.4 (With-profits insurance capital component)

01/10/2005

31/12/2004