INSPRU 1.3 With-profits insurance capital component

A realistic basis life firm means a firm to which GENPRU 2.1.18 R applies. The application of GENPRU 2.1.18 R is set out in GENPRU 2.1.19 R and GENPRU 2.1.20 R. GENPRU 2.1.13 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 GENPRU 2.1.38 R.

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

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 (INSPRU 1.2.9 R).

The required procedures are summarised in the flowchart in INSPRU 1 Annex 1.

1Future internal transfers from a with-profits fund are included in the realistic value of liabilities (see INSPRU 1.3.105 R, INSPRU 1.3.119 R, INSPRU 1.3.128 R and INSPRU 1.3.165 R). INSPRU 1.1.27 R ensures that sufficient assets are maintained in a with-profits fund to meet those future internal transfers. In calculating the WPICC, the economic value to the firm of those future transfers in the most adverse scenario required in calculating the risk capital margin (see INSPRU 1.3.43 R) should be recognised. In the case of internal transfers to a non-profit fund in respect of expense-related charges, those transfers may only be recognised to the extent that those cash flows have not already been taken into account in calculating the firm's capital resources or technical provisions. In effect, the future asset of the shareholders or another of the firm's funds is available to offset the corresponding liability of the with-profits fund and should, therefore, subject to the limitation in INSPRU 1.3.7R (2)(b)(iii), be treated as capital arising from that fund which is available to reduce the amount of the WPICC.

Subordinated debt which is subordinated to policyholder interests (see GENPRU 2.2.271 R) is an example of the sort of capital instrument that may give rise to a component of the WPICC under INSPRU 1.3.7R (3). Such instruments are treated as capital under GENPRU 2.2, subject to the requirements of GENPRU 2.2.271 R. Under realistic reserving the capital instrument is valued as a realistic liability (INSPRU 1.3.40 R) and in calculating the risk capital margin such an instrument would be valued at its realistic value in the single event outlined in INSPRU 1.3.43 R (see also INSPRU 1.3.162 R). Overall, the effect of GENPRU 2.2, INSPRU 1.3.7R (3) and INSPRU 1.3.43 R is to enable a firm that obtains subordinated debt to benefit from additional capital resources equal to the face amount of that debt.

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

1. (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:

   1. (a)

      advise 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;

   2. (b)

      perform that calculation in accordance with the methods and assumptions determined by the firm's governing body; and

   3. (c)

      report to the firm's governing body on the results of that calculation.

2. (2)

   As part of his duties under SUP 4.3.16G, 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 - seeCOBS 20.33) and with its regulatory duty to treat its customers fairly.

   3

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.

In this section, any reference to the Principles and Practices of Financial Management (PPFM) is a reference to the requirements inCOBS 20.33 (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.

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.

SYSC 14.1.53 R requires firms to maintain accounting and other records for a minimum of three years, or longer as appropriate. For the purposes of INSPRU 1.3.17 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. (1)

   the detailed guidance on record keeping in SYSC 14.1.51 G to SYSC 14.1.64 G;

2. (2)

   the nature and term of the firm's long-term insurance contracts; and

3. (3)

   any additional provisions or statutory requirements applicable to the firm or its records.

Some of the changes identified in accordance with INSPRU 1.3.19 R may have to be notified to the firm's policyholders in accordance with the firm's PPFM.

A firm needs to obtain an implicit item waiver from the FSA in order to bring in an amount under INSPRU 1.3.24R (1)(b). For guidance on applying for an implicit item waiver in respect of future surpluses relating to with-profits funds see GENPRU 2 Annex 8. The amount of any implicit item allocated to a with-profits fund may be defined in the terms of any waiver granted.

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. (1)

   the amount of 'Total other insurance and non-insurance liabilities'; and

2. (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 9.6R(1).

In INSPRU 1.3.33R (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 INSPRU 1.3.40R (3)).

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, INSPRU 1.3.33R (1)(e), INSPRU 1.3.33R (2) and INSPRU 1.3.33R (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 INSPRU 1.3.33R (3)(b)(v), INSPRU 1.3.33R (3)(b)(vi) and INSPRU 1.3.33R (3)(b)(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 INSPRU 1.3.45R (2)(c), INSPRU 1.3.33R (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 INSPRU 1.3.33R (3)(b)(iii), a firm may value the release of capital requirements as the business runs off (see INSPRU 1.3.38 G). INSPRU 1.3.33R (3)(b)(viii) ensures that any such capital is not double-counted.

In calculating the present value of future profits (or losses) for non-profit insurance business required by INSPRU 1.3.33R (1)(c), to the extent that the long-term insurance capital requirement is1 covered by the with-profits fund's long-term admissible assets, a firm may take into consideration any release of this item1 as the relevant policies go off the books.

Annuities do not typically fall to be valued on a market-consistent basis under INSPRU 1.3.37R (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 INSPRU 1.3.37R (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.

In view of INSPRU 1.3.39 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 INSPRU 1.3.37R (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 INSPRU 1.3.37R (2), might be applied).

In determining current market yields for the purpose of INSPRU 1.3.37R (4),2 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. In general, a1 firm should only1 include an allowance for future investment margins1 if its assumptions are limited to no more than a risk-free rate and the discount rate is set consistently. However, this does not preclude a firm from using a replicating portfolio of assets to determine the discount rate for the liability with suitable adjustments for differences in their characteristics (for the example of annuity business, see INSPRU 1.3.39 G). In setting assumptions for future investment returns, a firm should also consider sections BC134 to BC144 of the Basis for Conclusions in IFRS 4.1

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 INSPRU 1.3.40 R, including those in respect of guarantees and the value of options.

Detailed rules and guidance for the calculation of the three elements referred to in INSPRU 1.3.40 R are contained below in this section:

1. (1)

   INSPRU 1.3.116 R to INSPRU 1.3.135 G refer to the with-profits benefits reserve;

2. (2)

   INSPRU 1.3.136 G to INSPRU 1.3.189 G refer to the future policy related liabilities; and

3. (3)

   INSPRU 1.3.190 R and INSPRU 1.3.191 R refer to the realistic current liabilities.

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

1. (1)

   the fund's realistic value of liabilities;

2. (2)

   the value of assets identified, in accordance with INSPRU 1.3.43R (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.

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. INSPRU 1.3.43 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.

INSPRU 1.3.45R (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 (INSPRU 1.3.45R (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 INSPRU 1.3.43R (5)) as the amount taken into consideration is limited to 50% of the total present value.

A firm using a stochastic approach in INSPRU 1.3.169R (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 INSPRU 1.3.169R (2), may assume in estimating the market cost of hedging in the post-stress scenarios that market volatilities are unchanged.

In the scenario tests set out in INSPRU 1.3.62 R to INSPRU 1.3.103 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 INSPRU 1.3.43R (3).

In the scenario tests set out in INSPRU 1.3.62 R to INSPRU 1.3.103 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 INSPRU 1.3.45 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.

The management actions in INSPRU 1.3.53 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.

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.

In accordance with INSPRU 1.3.17 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).

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 INSPRU 1.3.17 R of the amount of any such charges to its customers and of how it has ensured their fair treatment.

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.

In calculating the persistency scenario in INSPRU 1.3.100 R, a firm needs to make assumptions regarding the future termination rates exhibited by policies, at points described in particular in INSPRU 1.3.101 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.

Guidance on how a firm should determine where particular assets are invested is provided in INSPRU 3.1.13B G.

In determining its most adverse scenario, a firm applying INSPRU 1.3.68 R and INSPRU 1.3.73 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 INSPRU 1.3.43 R.

In relation to the market risk scenarios in INSPRU 1.3.68 R and INSPRU 1.3.73 R, the effect of INSPRU 1.3.52 R and INSPRU 1.3.58 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.1

The relevant assets identified under INSPRU 1.3.43R (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. INSPRU 1.3.43R (5) exempts such an asset from the market risk stress tests.

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 INSPRU 1.3.68R (3), the firm would assume a fall or rise of up to 1.05 percentage points in yields on all fixed interest securities.

For the purposes of INSPRU 1.3.73R (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. (1)

   an appropriate equity market index (or indices) for that territory; and

2. (2)

   the historical volatility of the equity market index (or indices) selected in (1).

For the purpose of INSPRU 1.3.75G (1), an appropriate equity market index (or indices) for a territory should be such that:

1. (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 INSPRU 1.3.43R (2); and

2. (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.

1. (1)

   The purpose of the credit risk scenarios in INSPRU 1.3.78 R to INSPRU 1.3.99 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 INSPRU 3.1.

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. (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. (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. (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 INSPRU 1.3.43 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.

The change in asset or liability values to be determined in relation to a credit risk scenario for the purposes of INSPRU 1.3.43 R and INSPRU 1.3.44 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.

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.

1. (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 INSPRU 1.3.90 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. (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. (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. (4)

   In arriving at the estimated gross redemption yield in INSPRU 1.3.84R (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.

Under INSPRU 1.3.87R (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.

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").

1. (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 in respect of contracts of insurance that are analogous to contracts of reinsurance in terms of the risks transferred and the finance provided.

2. (2)

   In assessing values in accordance with INSPRU 1.3.94 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 INSPRU 1.3.84 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 INSPRU 1.3.92 R for the nomination of financial strength ratings. Table INSPRU 1.3.97 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. (3)

   The changes in credit risk spreads determined for bond and debt items in accordance with INSPRU 1.3.78R (1) are required to result in a reduction in market value for some items of 5% of their current value through the operation of INSPRU 1.3.84R (2)(b). For reinsurance contracts and analogous non-reinsurance financing agreements, determining the change in value by reference to INSPRU 1.3.94R (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. INSPRU 1.3.94R (4) relates to this requirement.

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.

In applying INSPRU 1.3.98 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 (INSPRU 1.3.87 R. INSPRU 1.3.77G (5) is also relevant in this context.

INSPRU 1.3.100 R to INSPRU 1.3.102 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 INSPRU 1.3.33 R) there is no requirement to stress this asset for changes in persistency assumptions.

INSPRU 1.3.40 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. (1)

   general rules and guidance in INSPRU 1.3.105 R to INSPRU 1.3.115 G;

2. (2)

   with-profits benefits reserve in INSPRU 1.3.116 R to INSPRU 1.3.135 G;

3. (3)

   future policy related liabilities in INSPRU 1.3.136 G to INSPRU 1.3.189 G; and

4. (4)

   realistic current liabilities in INSPRU 1.3.190 R and INSPRU 1.3.191 R.

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 INSPRU 1.2.10R (4) and INSPRU 1.2.13 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.

The amount and timing of tax charges affect the amount of assets available to meet policyholder liabilities. INSPRU 1.3.105R (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.

Where a firm has grouped individual contracts for the purpose of calculating the mathematical reserves for a with-profits fund (in accordance with INSPRU 1.2.22 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.

In contrast to INSPRU 1.2.24 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.

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 INSPRU 1.3.116 R. In particular, the calculation of aggregate retrospective reserves (see INSPRU 1.3.118 R) and the projection of future cash flows (see INSPRU 1.3.128 R) based on suitable specimen policies is permitted.

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.

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.

In taking account of amounts in INSPRU 1.3.119R (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 in respect of contracts of insurance that are analogous to contracts of reinsurance in terms of the risks transferred and the finance provided.

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.

An example of INSPRU 1.3.123 R concerns future shareholder transfers. A firm must make adequate provision for future shareholder transfers within the future policy related liabilities (see INSPRU 1.3.165 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.

Another example of the application of INSPRU 1.3.123 R relates to the reference in INSPRU 1.3.119R (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 INSPRU 1.3.137 R).

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. INSPRU 1.3.119 R simply sets minimum standards that all retrospective methods must meet.

For the purposes of INSPRU 1.3.119R (2) and INSPRU 1.3.128R (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.

The prospective method sets the with-profits benefits reserve at the net present value of future cash flows listed in INSPRU 1.3.128 R.

In contrast to INSPRU 1.2.10R (4) and INSPRU 1.2.13 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 INSPRU 1.3.130 R.

In valuing the future cash flows listed in INSPRU 1.3.128 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.

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.

Overview of liabilities

INSPRU 1.3.137 R lists the future policy related liabilities for a with-profits fund that form part of a firm's realistic value of liabilities in INSPRU 1.3.40 R. Detailed rules and guidance relating to particular types of liability and asset are set out in INSPRU 1.3.139 R to INSPRU 1.3.168 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. (1)

   INSPRU 1.3.169 R to INSPRU 1.3.186 G refer to valuing the costs of guarantees, options and smoothing; and

2. (2)

   INSPRU 1.3.187 R to INSPRU 1.3.189 G refer to the treatment of surplus on guarantees, options and smoothing.

Some of the elements of the calculation set out in INSPRU 1.3.137 R may have already been taken into consideration in the calculation of the with-profits benefits reserve, either under the retrospective method (see INSPRU 1.3.118 R onwards) or the prospective method (see INSPRU 1.3.128 R onwards). Where this is the case, the adjustments made under INSPRU 1.3.137 R should be such that no double-counting arises.

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 INSPRU 1.3.119R (8).

For the purposes of INSPRU 1.3.141 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.

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 INSPRU 1.3.169 R to INSPRU 1.3.186 G.

In calculating future policy related liabilities for a with-profits fund, a firm should take credit under INSPRU 1.3.137R (3) for the present value of the future "margins" available in respect of charges deducted to cover the costs of guarantees, options and smoothing. INSPRU 1.3.188 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 INSPRU 1.3.137R (5), INSPRU 1.3.137R (7) or INSPRU 1.3.137R (8) depending on the nature of the charges made, and has no effect on the amount calculated under INSPRU 1.3.144 R.

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

1. (1)

   where a firm is targeting claims at less than 100% of the with-profits benefits reserve, the amount of such shortfall; and

2. (2)

   where a firm expects to deduct any future charges (other than those for guarantees, options and smoothing) from the with-profits benefits reserve.

In carrying out projections to calculate the cost of guarantees under INSPRU 1.3.137 R the opening liability should be set equal to the with-profits benefit reserve (see INSPRU 1.3.118 R), adjusted for miscellaneous surplus or deficits (see INSPRU 1.3.137R (1)) and planned enhancements (see INSPRU 1.3.141 R).

In projecting forward the with-profits benefits reserve, adjusted as in INSPRU 1.3.150 G, to the date of claim for the purposes of INSPRU 1.3.148 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 INSPRU 1.3.130 R.

INSPRU 1.3.169 R to INSPRU 1.3.186 G contain further rules and guidance on the valuation of guarantees, options and smoothing.

Some examples of contractual guarantees are:

1. (1)

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

2. (2)

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

Some examples of these non-contractual commitments are:

1. (1)

   statements by the firm regarding the ability of policies to cover defined amounts, such as the repayment of a mortgage;

2. (2)

   statements by the firm regarding regular withdrawals from a policy being without penalty;

3. (3)

   guaranteed annuity and cash option rates being provided beyond the strict interpretation of the policy; and

4. (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.

Financial options include guaranteed annuity and cash option rates.

INSPRU 1.3.169 R to INSPRU 1.3.186 G contain further rules and guidance on the valuation of options.

INSPRU 1.3.169 R to INSPRU 1.3.186 G contain further rules and guidance on the valuation of the future costs of smoothing.

In INSPRU 1.3.162 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. (1)

   where a firm has no liability to repay such financing, it should not include such repayment as a liability;

2. (2)

   where a firm has a reduced liability to repay such financing, it should include a reduced repayment as a liability.

In INSPRU 1.3.162 R, financing includes reinsurance financing arrangements and analogous non-reinsurance financing arrangements, such as contingent loans, securitisations and any other arrangements in respect of contracts of insurance that are analogous to contracts of reinsurance in terms of the risks transferred and the finance provided.

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

1. (1)

   pension and other mis-selling reserves;

2. (2)

   provisions for tax; and

3. (3)

   provisions for future shareholder transfers.

In determining the realistic liability for taxation firms should apply the general principles set out in INSPRU 1.3.105 R and the guidance given in INSPRU 1.3.107 G.

INSPRU 1.3.105 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.

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.

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.

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 (INSPRU 1.3.185 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.

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).

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

1. (1)

   the consistency of its assumptions (including the exercise of management discretion over bonus rates); and

2. (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.

For the purposes of INSPRU 1.3.169R (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.

In performing the projections of assets and liabilities under the stochastic approach in INSPRU 1.3.169R (1), a firm should have regard to the aspects in (1) and (2).

1. (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. (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.

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.

Where a stochastic approach is used, a firm should make and retain a record under INSPRU 1.3.17 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).

In calibrating asset models for the purposes of INSPRU 1.3.170 R, a firm should have regard to the aspects in (1), (2) and (3).

1. (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. (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 INSPRU 1.3.17 R of the choice of parameters and the reasons for their use.

3. (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 professionon the calculation of the risk-free yield but should not assume a higher yield than suggested by any such guidance.

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.

In performing the projections of assets and liabilities under the deterministic approach in INSPRU 1.3.169R (3), a firm should have regard to the aspects in (1) and (2).

1. (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. (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.

Where a series of deterministic projections is used, a firm should make and retain a record under INSPRU 1.3.17 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).

For the purposes of INSPRU 1.3.185 R, the related guidance in INSPRU 1.3.54 G to INSPRU 1.3.57 G (management actions) and in INSPRU 1.3.60 G (policyholder actions) applies.

The extent to which the amount in INSPRU 1.3.188R (2) exceeds the amount in INSPRU 1.3.188R (1) will determine the surplus available to support actions that would be taken by the firm's management. The purpose of INSPRU 1.3.188 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 INSPRU 1.3.188 R is added to the liabilities under INSPRU 1.3.137R (5), INSPRU 1.3.137R (7) and INSPRU 1.3.137R (8), but has no impact on the adjustment for planned deductions for the costs of guarantees, options and smoothing (INSPRU 1.3.137R (3) and INSPRU 1.3.144 R).