INSPRU 1.5 Internal-contagion risk

The scope of application of INSPRU 1.5 is not restricted to firms that are subject to the relevant EC directives.

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.

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

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 INSPRU 6.

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

1. (1)

   both insurance and non-insurance activities; or

2. (2)

   two or more different types of insurance activity; or

3. (3)

   insurance activities from offices or branches located in both the United Kingdom and overseas.

This section requires firms other than pure reinsurers 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. pure reinsurers must limit their activities to the business of reinsurance and related operations.

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. (1)

   general insurance business and long-term insurance business;

2. (2)

   linked and non-linked insurance business.

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.

In INSPRU 1.5.13A R related operations include, for example, activities such as provision of statistical or actuarial advice, risk analysis or research for its clients. It may also include a holding company function and activities with respect to financial sector activities within the meaning of Article 2, point 8, of the Financial Groups Directive. But it does not allow the carrying on of, for example, unrelated banking and financial activities.

For the purpose of INSPRU 1.5.14 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.

INSPRU 1.5.18 R, INSPRU 1.5.21 R, INSPRU 1.5.30 R and INSPRU 1.5.31 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.

1. (1)

   Under section 19 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.3

2. (2)

   A firm's permission can be varied so as to add other classes. The permission of an existing composite firm may be varied by adding classes of both general insurance business and long-term insurance business. 3

3. (3)

   It is FSA policy, in compliance with EC directives on insurance, not to grant or vary permission if that would allow a newly established firm, or an existing firm engaging solely in general insurance business or solely in long-term insurance business, to engage in both general insurance business and long-term insurance business. This does not apply where a firm's permission to carry on long-term insurance business is or is to be restricted to reinsurance. It also does not apply where a firm's permission to carry on general insurance business is or is to be restricted to effecting or carrying out accident or sickness contracts of insurance (see article 18(2) of the Consolidated Life Directive). 3

4. (4)

   Where a firm's permission extends to effecting or carrying out life and annuity contracts of insurance this will normally include permission to effect or carry out accident contracts of insurance or sickness contracts of insurance on a supplementary basis (see article 2(1)(c) of the Consolidated Life Directive).3

1. (1)

   INSPRU 1.1.16 R requires a firm to establish adequate technical provisions for its long-term insurance contracts. INSPRU 1.1.20 R requires a firm which is not a composite 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. INSPRU 1.1.21 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.3

2. (2)

   In the case of a firm carrying on long-term insurance business which is not a pure reinsurer, there are excluded from the scope of INSPRU 1.1.20 R and INSPRU 1.1.21 R property-linked liabilities and index-linked liabilities and the assets held to cover them under INSPRU 3.1.57 R and INSPRU 3.1.58 R. The latter two rules do not apply to a pure reinsurer (see INSPRU 3.1.58A R). However, a pure reinsurer is required by INSPRU 3.1.61A R to invest all its assets in accordance with the requirements of that rule.3

3. (3)

   The overall impact of these provisions in INSPRU 1.1 and INSPRU 3.1, when read together with INSPRU 1.5.18 R, is that any firm writing long-term insurance business must identify separately assets of a value at least equal to the amount of its long-term insurance business technical provisions, including those in respect of any property-linked liabilities or index-linked liabilities, and its other long-term insurance liabilities.3

INSPRU 1.5.18 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 INSPRU 1.5.21 R and INSPRU 1.5.22 R ) and the transfer will take effect when it is recorded in the firm's accounting records (see INSPRU 1.5.23 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 INSPRU 1.5.27 R).

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.

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.

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 COBS 20.32) 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.

As a result of INSPRU 1.5.27R (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 INSPRU 1.1.20 R or INSPRU 1.1.21 R.

INSPRU 1.1.27 R and INSPRU 1.1.28 R provide further constraints on the transfer of assets out of a with-profits fund. INSPRU 1.1.27 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. INSPRU 1.1.28 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.

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.

INSPRU 1.5.2 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.

INSPRU 3.1.57 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.

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.

The purpose of the rules and guidance set out in INSPRU 1.5.38 G to INSPRU 1.5.57 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.

By virtue of INSPRU 1.5.2R (4), the rules in INSPRU 1.5.41 R to INSPRU 1.5.57 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.

1. (1)

   INSPRU 1.5.41 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. (2)

   INSPRU 1.5.42 R to INSPRU 1.5.47 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. (3)

   INSPRU 1.5.48 R to INSPRU 1.5.52 R require non-EEA direct insurers to hold a minimum level of assets in the United Kingdom or EEA.

4. (4)

   INSPRU 1.5.54 R requires the deposit of a minimum level of assets in the United Kingdom.

5. (5)

   INSPRU 1.5.56 R and INSPRU 1.5.57 R require non-EEA direct insurers to keep adequate accounting records in the United Kingdom.

The admissible assets in excess of the technical provisions and UK or EEA MCR may be held outside the EEA.

INSPRU 3.1.53 R to INSPRU 3.1.55R (currency matching of assets and liabilities) apply to the assets held to match insurance liabilities calculated under INSPRU 1.1.12 R or INSPRU 1.1.16 R.

The assets deposited as security may count towards the assets required under INSPRU 1.5.48 R and INSPRU 1.5.49 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 INSPRU 1.5.48 R and INSPRU 1.5.49 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 INSPRU 1.5.48 R or INSPRU 1.5.49 R.