INSPRU 3.2 Derivatives in insurance

This section applies to an insurer, unless it is:

1. (1)

   a non-directive friendly society; or

2. (2)

   an incoming EEA firm; or

3. (3)

   an incoming Treaty firm; or

4. (4)

   a pure reinsurer; or5

   5
5. (5)

   a Solvency II firm.5

1. (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. (2)

   Where a firm carries on both long-term insurance business and general insurance business, this section applies separately to each type of business.

For the purpose of PRA Rulebook: Non-Solvency II firms: Insurance Company – Capital Resources 136 (Admissible assets in insurance), and also in relation to permitted links,1 a derivative or quasi-derivative is approved if:

1. (1)

   it is held for the purpose of efficient portfolio management (INSPRU 3.2.6 R to INSPRU 3.2.7 R) or reduction of investment risk (INSPRU 3.2.8 R to INSPRU 3.2.13 G);

2. (2)

   it is covered (INSPRU 3.2.14 R to INSPRU 3.2.33 G); and

3. (3)

   it is effected or issued:

   1. (a)

      on or under the rules of a regulated market; or

   2. (b)

      off-market with an approved counterparty and, except for a forward transaction, on approved terms and is capable of valuation (INSPRU 3.2.34 R to INSPRU 3.2.35 R).

A derivative or quasi-derivative is held for the purpose of efficient portfolio management if the firm reasonably believes the derivative or quasi-derivative (either alone or together with any other covered transactions) enables the firm to achieve its investment objectives by one of the following (or, in relation to permitted links, in a manner which includes but is not limited to)1:

1. (1)

   generating additional capital or income in one of the ways described in INSPRU 3.2.7 R; or

2. (2)

   reducing tax or investment cost in relation to admissible assets or permitted links1; or

3. (3)

   acquiring or disposing of rights in relation to admissible assets or permitted links1, or their equivalent, more efficiently or effectively.

The generation of additional capital or income falls within INSPRU 3.2.6R (1) where it arises from:

1. (1)

   taking advantage of pricing imperfections in relation to the acquisition and disposal (or disposal and acquisition) of rights in relation to assets the same as, or equivalent to, admissible assets or permitted links1; or

2. (2)

   receiving a premium for selling a covered call option or its equivalent, the underlying of which is an admissible asset or permitted link1, even if that additional capital or income is obtained at the expense of surrendering the chance of greater capital or income.

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

For the purposes of INSPRU 3.2.8 R, an increase in risk from a derivative or quasi-derivative is significant unless:

1. (1)

   relative to any reduction in investment risk it is both small and reasonable; or

2. (2)

   the risk is remote.

For the purposes of INSPRU 3.2.8 R, investment risk is the risk that the assets held by a firm:

1. (1)

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

   1. (a)

      of a value at least equal to the amount of those technical provisions as required by PRA Rulebook: Non-Solvency II firms: Insurance Company – Technical Provisions, 46; or

   2. (b)

      of appropriate safety, yield and marketability as required by PRA Rulebook: Non-Solvency II firms: Insurance Company – Technical Provisions, 6.2(1)6; or

   3. (c)

      of an appropriate currency match as required by PRA Rulebook:Non-Solvency II firms: Insurance Company – Risk Management, 3.26;

2. (2)

   (where they are held to cover index-linked liabilities) might not be appropriate cover for those liabilities as required by INSPRU 3.1.58 R; and

3. (3)

   (where they are held to cover property-linked liabilities) might not be appropriately selected in accordance with contractual and constructive liabilities6 and appropriate cover for those liabilities as required by PRA Rulebook: Non-Solvency II firms: Insurance Company – Risk Management, in particular the definition of ‘investment risk’6.

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

1. (1)

   a derivative or quasi-derivative; or

2. (2)

   a contract (other than a contract of insurance) for the purchase, sale or exchange of assets.

An obligation to transfer assets or pay monetary amounts (see INSPRU 3.2.14 R) must be covered:

1. (1)

   by assets, a liability or a provision (see INSPRU 3.2.16 R to INSPRU 3.2.24 R); or

2. (2)

   by an offsetting transaction (see INSPRU 3.2.25 R to INSPRU 3.2.27 R).

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

1. (1)

   those assets; or

2. (2)

   in the case of an index or basket of assets, a reasonable approximation to those assets.

An obligation to pay a monetary amount (whether or not falling in INSPRU 3.2.16 R) is covered if:

1. (1)

   the firm holds admissible assets or permitted links1 that are sufficient in value so that the firm reasonably believes that following reasonably foreseeable adverse variations (relying solely on cashflows from, or from realising, those assets) it could pay the monetary amount in the right currency when it falls due; or

2. (2)

   the obligation to pay the monetary amount is offset by a liability. An obligation is offset by a liability where an increase in the amount of that obligation would be offset by a decrease in the amount of that liability; or

3. (3)

   a provision at least equal to the value of the assets in (1) is implicitly or explicitly set up. A provision is implicitly set up to the extent that the obligation to pay the monetary amount is recognised under PRA Rulebook: Non Solvency II firms: Insurance Company – Overall Resources and Valuation, in particular chapters 3-7,6 either by offset against an asset or as a separate liability. A provision is explicitly set up if it is in addition to an implicit provision.

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

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

An offsetting transaction means:

1. (1)

   an approved derivative, approved stock lending transaction or an approved quasi-derivative; or

2. (2)

   a covered transaction with an approved counterparty for the purchase of assets.

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

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

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

1. (1)

   they are non-monetary assets that have been lent under a transaction that fulfils the conditions in INSPRU 3.2.36 R; and

2. (2)

   the firm reasonably believes the assets to be obtainable (by return or re-acquisition) in time to meet the obligation for which cover is required.

Assets that have been borrowed by the firm are not available for cover except as allowed by INSPRU 3.2.30 R.

Borrowed money may be used as cover only where:

1. (1)

   the money has been advanced or an approved credit institution has committed itself to advance the money; and

2. (2)

   the borrowing is or would be covered.

For the purpose of INSPRU 3.2.5R (3)(b), a derivative or quasi-derivative is on approved terms only if the firm reasonably believes that it could, in all reasonably foreseeable circumstances and under normal market conditions, readily enter into a further transaction with the counterparty or a third party to close out the derivative or quasi-derivative at a price not less than the value attributed to it by the firm, taking into account any valuation adjustments or reserves established by the firm under PRA Rulebook: Non-Solvency II firms: Insurance Company – Overall Resources and Valuation, in particular chapter 76.

For the purpose of INSPRU 3.2.5R (3)(b), a derivative or quasi-derivative is capable of valuation only if the firm:

1. (1)

   is able to value it with reasonable accuracy on a reliable basis in compliance with PRA Rulebook: Non-Solvency II firms: Insurance Company – Overall Resources and Valuation, 3.16; and

2. (2)

   reasonably believes that it will be able to do so throughout the life of the transaction.

1. (1)

   For the purposes of PRA Rulebook: Non-Solvency II firms: Insurance Company – Capital Resources 136 (Admissible assets in insurance), a stock lending transaction (including a repo transaction) 3is approved if:

   1. (a)

      the assets lent are admissible assets;

   2. (b)

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

      1. (i)

         the Office of the Comptroller of the Currency;

      2. (ii)

         the Federal Deposit Insurance Corporation;

      3. (iii)

         the Board of Governors of the Federal Reserve System; and

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   3. (c)

      adequate and sufficiently immediate collateral (INSPRU 3.2.38 R to INSPRU 3.2.41 R) is obtained to secure the obligation of the counterparty.

2. (2)

   INSPRU 3.2.36R (1)(c) does not apply to a stock lending transaction made through Euroclear Bank SA/NV's Securities Lending and Borrowing Programme.

1. (1)

   1For the purposes of the rules on permitted links, a stock lending transaction (including a repo transaction) is approved if:

   1. (a)

      the assets lent are permitted links;

   2. (b)

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

      1. (i)

         the Office of the Comptroller of the Currency;

      2. (ii)

         the Federal Deposit Insurance Corporation;

      3. (iii)

         the Board of Governors of the Federal Reserve System; and

         6

   3. (c)

      adequately and sufficiently immediate collateral (INSPRU 3.2.38 R to INSPRU 3.2.41 R) is obtained to secure the obligation of the counterparty; and

   4. (d)

      provided that, for the purposes of property-linked assets only:

      1. (i)

         where the linked policyholder bears the whole of the risk associated with the stock lending transaction, they must receive the whole of the recompense (net of fees and expenses);

      2. (ii)

         the extent of any risk that the linked policyholder bears in relation to the stock lending transaction must be disclosed to them; and

      3. (iii)

         where the risk associated with the stock lending transaction is borne outside the linked fund, the linked fund should receive a fair and reasonable recompense for the use of the linked policyholders' funds.

2. (2)

   INSPRU 3.2.36R (1)(c) does not apply to a stock lending transaction made through Euroclear Bank SA/NVs Securities Lending and Borrowing Programme.

For the purposes of INSPRU 3.2.36R (1)(c), collateral is adequate only if it:

1. (1)

   is transferred to the firm or its agent or, in the case of a letter of credit, meets the conditions described in INSPRU 3.2.38A R;

2. (2)

   is, at the time of the transfer or, in the case of a letter of credit, at the time of issue, at least equal in value to the value of the securities transferred, or consideration provided, by the firm; and

3. (3)

   is of adequate quality.

The conditions referred to in INSPRU 3.2.38R (1) are that the letter of credit is:

1. (1)

   direct, explicit, unconditional and irrevocable; and

2. (2)

   issued by an undertaking which is:

   1. (a)

      not a related undertaking of the counterparty; and

   2. (b)

      either an approved credit institution or a bank, or a branch of a bank, whether chartered by the federal government of the United States of America or a US state, that is supervised and examined by at least one of the following US federal banking supervisory authorities:

      1. (i)

         the Office of the Comptroller of the Currency;

      2. (ii)

         the Federal Deposit Insurance Corporation;

      3. (iii)

         the Board of Governors of the Federal Reserve System6

For the purposes of INSPRU 3.2.36R (1)(c), collateral is sufficiently immediate only if:

1. (1)

   it is transferred or, in the case of a letter of credit, issued before, or at the same time as, the transfer of the securities by the firm; or

2. (2)

   it will be transferred or, in the case of a letter of credit, issued, at latest, by the close of business on the day of the transfer.

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