The scope of application of PRU 2.1 is not restricted to firms that are subject to the relevant EC Directives. It applies, for example, to pure reinsurers.

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

The requirements in PRU 2.1 apply to a firm on a solo basis.

Principle 4 requires a firm to maintain adequate financial resources. PRU 2 sets out provisions that deal specifically with the adequacy of that part of a firm's financial resources that consists of capital resources. The adequacy of a firm's capital resources needs to be assessed both by the firm and the FSA. Through its rules, the FSA sets minimum capital resources requirements for firms. It also reviews a firm's own assessment of its capital needs, and the processes and systems by which that assessment is made, in order to see if the minimum capital resources requirements are appropriate (see PRU 2.3.2 G to PRU 2.3.3 G).

This section (PRU 2.1) sets capital resources requirements for a firm. PRU 2.2 sets out how, for the purpose of this, the amounts or values of capital, assets and liabilities are to be determined. More detailed rules relating to capital, assets and liabilities are also set out in the following chapters and sections:

1. (1)

   PRU 1.3 Valuation;

2. (2)

   PRU 3 Credit risk;

3. (3)

   PRU 4 Market risk;

4. (4)

   PRU 5 Liquidity risk;

5. (5)

   PRU 6 Operational risk;

6. (6)

   PRU 7 Insurance risk; and

7. (7)

   PRU 8 Group risk.

PRU 2.1 and PRU 2.2 include appropriate cross-references to these chapters and sections.

PRU 2.1 implements minimum EC standards for the capital resources required to be held by a firm undertaking business that falls within the scope of the Consolidated Life Directive (2002/83/EC) or the First Non-Life Directive (73/239/EEC) as amended.

In order to comply with PRU 2.1.10 R, a firm carrying on both general insurance business and long-term insurance business will need to allocate its capital resources between its general insurance business and long-term insurance business so that the capital resources allocated to its general insurance business are equal to or in excess of its CRR for its general insurance business and the capital resources allocated to its long-term insurance business are equal to or in excess of its CRR for its long-term insurance business. Whereas long-term insurance assets cannot be used towards meeting a firm's CRR for its general insurance business, surplus general insurance assets may be used towards meeting the CRR for its long-term insurance business (see PRU 7.6.30 R to PRU 7.6.32 G). PRU 7.6 sets out the detailed requirements for the separation of long-term and general insurance business.

Firms commonly use different terminology for the various PRU requirements. For example, the MCR is traditionally known as the required minimum margin.

The FSA may impose a higher capital requirement than the minimum requirement set out in this section as part of the firm's Part IV permission. (See PRU 2.3).

The effect of PRU 2.1.16 R (3) is that a firm to which PRU 2.1.15 R applies because it has with-profits insurance liabilities of £500 million or more, will continue to be subject to PRU 2.1.15 R even if its with-profits insurance liabilities fall below £500 million. However, if that happens, it may apply for a waiver from PRU 2.1.15 R under section 148 of the Act. In exercising its discretion under section 148 of the Act, the FSA will have regard (among other factors) to whether there has been a material and permanent change to the firm's business and to the prospects of it continuing to have with-profits insurance liabilities of less than £500 million.

A firm that has always had with-profits insurance liabilities of less than £500 million since PRU 2.1.15 R came into force may wish to "opt in" to PRU 2.1.15 R and therefore become a realistic basis life firm. By doing so, it becomes obliged to calculate a with-profits insurance capital component (see PRU 2.1.34 R and PRU 7.4), but it also becomes entitled to certain modifications to the way that a firm is required to calculate its mathematical reserves (see PRU 7.3.46 R and PRU 7.3.76 R). The firm is also then required to report its liabilities on a realistic basis (see IPRU(INS) rule 9.31R(b)). In order to "opt in", the firm must make an election under PRU 2.1.17 R that PRU 2.1.15 R is to apply to it. If a firm that has elected to calculate and report its with-profits insurance liabilities on a realistic basis subsequently decides that it no longer wishes to do so, it may seek to "opt out" by applying for a waiver from PRU 2.1.15 R under section 148 of the Act. In exercising its discretion under section 148 of the Act, the FSA will have regard (among other factors) to whether there has been a material and permanent change to the firm's business and to whether it continues to have with-profits insurance liabilities of less than £500 million.

The MCR gives effect to the EC Directive minimum requirements. For general insurance business, the EC Directive minimum is the higher of the general insurance capital requirement and the relevant base capital resources requirement. For long-term insurance business, the EC Directive minimum is the higher of the long-term insurance capital requirement and the base capital resources requirement. The base capital resources requirement is the minimum guarantee fund for the purposes of article 29(2) of the Consolidated Life Directive (2002/83/EC) and article 17(2) of the First Non-Life Directive (73/239/EEC) as amended. The resilience capital requirement is an FSA requirement that is additional to the EC minimum requirement for long-term insurance business.

The calculation of the resilience capital requirement is set out in PRU 4.2.

Any increases in the base capital resources requirement referred to in PRU 2.1.27 R will be published on the FSA website.

The calculation of each of the premiums amount, claims amount and brought forward amount is set out in PRU 7.2.

The calculation of each of the capital components is set out in PRU 7.2.

Details of the resilience capital requirement and the with-profits insurance capital component are set out in PRU 4.2 and PRU 7.4 respectively.

For the purposes of PRU 2.1.36 R, a firm should have systems in place to enable it to be certain whether it has adequate capital resources to comply with PRU 2.1.9 R at all times. This does not necessarily mean that a firm needs to measure the precise amount of its capital resources and its CRR on a daily basis. A firm should, however, be able to demonstrate the adequacy of its capital resources at any particular time if asked to do so by the FSA.

PRU 2.1 sets out minimum capital resources requirements for a firm. This section (PRU 2.2) sets out how, for the purpose of these requirements, capital resources are defined and measured. PRU 2.2 also implements minimum EC standards for the composition of capital resources required to be held by a firm undertaking business that falls within the scope of the Consolidated Life Directive (2002/83/EC) or the First Non-Life Directive (73/239/EEC) as amended.

The FSA has divided its definition of capital into categories, or tiers, reflecting differences in the extent to which the capital instruments concerned meet the purpose and conform to the characteristics of capital listed in PRU 2.2.5 G. The FSA generally prefers a firm to hold higher quality capital that meets the characteristics of permanency and loss absorbency that are features of tier one capital. Capital instruments falling into core tier one capital can be included in a firm's regulatory capital without limit. Typically, other forms of capital are either subject to limits (see PRU 2.2.16 R to PRU 2.2.26 R) or, in the case of some specialist types of capital, may only be included with the express consent of the FSA (which takes the form of a waiver under section 148 of the Act).

Details of the individual components of capital are set out in PRU 2.2.14 R.

Tier one capital typically has the following characteristics:

1. (1)

   it is able to absorb losses;

2. (2)

   it is permanent;

3. (3)

   it ranks for repayment upon winding up after all other debts and liabilities; and

4. (4)

   it has no fixed costs, that is, there is no inescapable obligation to pay dividends or interest.

The forms of capital that qualify for tier one capital are set out in PRU 2.2.14 R and include, for example, share capital, reserves, verified interim net profits and, for a mutual, the initial fund plus permanent members' accounts. Tier one capital is divided into core tier one capital, perpetual non-cumulative preference shares, and innovative tier one capital.

Tier two capital includes forms of capital that do not meet the requirements for permanency and absence of fixed servicing costs that apply to tier one capital. Tier two capital includes, for example:

1. (1)

   capital which is perpetual (that is, has no fixed term) but cumulative (that is, servicing costs cannot be waived at the issuer's option, although they may be deferred - for example cumulative preference shares); perpetual capital instruments may be included in upper tier two capital; and

2. (2)

   capital which is not perpetual (that is, it has a fixed term) and which may also have fixed servicing costs that cannot generally be either waived or deferred, for example subordinated debt. Such capital should normally be of a medium to long-term maturity (that is, an original maturity of at least five years). Dated capital instruments are included in lower tier two capital.

Deductions should be made at the relevant stage of the calculation of capital resources to reflect capital that may not be available to the firm or assets of uncertain value, for example, holdings of intangible assets and assets that are inadmissible for a firm.

A full list of deductions from capital resources is shown in PRU 2.2.14 R.

Capital resources can be calculated either as the total of eligible assets less foreseeable liabilities (which is the approach taken in the Insurance Directives) or by identifying the components of capital. Both calculations give the same result for the total amount of capital resources. The approach taken in this section has been to specify the components of capital and the relevant deductions. This is set out in PRU 2.2.14 R. This approach is the same as that used for the calculation of capital resources for banks, building societies and investment firms. A simple example, showing the reconciliation of the two methods, is given in PRU 2.2.11 G.

Where PRU 2.2.14 R refers to related text, it is necessary to refer to that text in order to understand fully what is included in the descriptions of capital items and deductions set out in the table.

As the various components of capital differ in the degree of protection that they offer the firm and its customers, restrictions are placed on the extent to which certain types of capital are eligible for inclusion in a firm's capital resources. These restrictions are set out in PRU 2.2.16 R to PRU 2.2.26 R.

The purposes of the requirements in PRU 2.2.16 R to PRU 2.2.18 R are to comply with the Insurance Directives' requirement that firms maintain a guarantee fund of higher quality capital resources items and to ensure that at least 50% of the firm's capital resources needed to meet its MCR provide maximum loss absorbency to protect the firm from insolvency.

The purpose of the requirement in PRU 2.2.20 R (1) is to ensure that at least 50% of the firm's tier one capital resources (net of tier one capital deductions) is met by core tier one capital which provides maximum loss absorbency on a going concern basis to protect the firm from insolvency. Although a perpetual non-cumulative preference share is in legal form a share, it behaves in many ways like a perpetual fixed interest debt instrument. Within the 50% limit on non-core tier one capital, PRU 2.2.20 R (2) places a further sub-limit on the amount of innovative tier one capital that a firm may include in its tier one capital resources. This limit is necessary to ensure that most of a firm's tier one capital comprises items of capital of the highest quality.

PRU 2.2.23 R and PRU 2.2.24 R give effect to the Insurance Directives' requirements that a firm's tier two capital resources must not exceed its tier one capital resources and that no more than 25% of a firm's "required solvency margin" should consist of lower tier two capital resources.

PRU 2.2.29 R (2) is stricter than the Companies Act definition of fully paid, which only requires an undertaking to pay.

An item of capital does not comply with PRU 2.2.29 R (8) if it is marketed as a capital instrument that would only qualify for a lower level of capital or on the basis that investing in it is like investing in a lower tier two instrument. For example, an undated capital instrument should not be marketed as a dated capital instrument if the terms of the capital instrument include an option by the issuer to redeem the capital instrument at a specified date in the future.

For the purposes of PRU 2.2.30 R, examples of connected transactions might include guarantees or any other side agreement provided to the holders of the capital instrument by the firm or a connected party or a related transaction designed, for example, to enhance their security or to achieve a tax benefit, but which may compromise the loss absorption capacity or permanence of the original capital item.

PRU 2.2.36 R has the effect that the firm should be under no obligation to make any payment in respect of a tier one instrument if it is to form part of its permanent share capital unless and until the firm is wound up. A tier one instrument that forms part of permanent share capital could not therefore count as a liability before the firm is wound up. The fact that relevant company law permits the firm to make earlier repayment does not mean that the tier one instruments are not eligible. However, the firm should not be required by any contractual or other obligation arising out of the terms of that capital to repay permanent share capital. Similarly a tier one instrument may still qualify if company law allows dividends to be paid on this capital, provided the firm is not contractually or otherwise obliged to pay them. There should therefore be no fixed costs.

PRU 2.2.38 R does not apply to permanent share capital because no item of capital that is either redeemable or that has a cumulative coupon can be permanent share capital.

The rules in PRU 2.2 about redemption of potential tier one instruments fall into three classes:

1. (1)

   rules defining whether a firm's potential tier one instruments are eligible for inclusion in its tier one capital resources at all;

2. (2)

   rules defining whether a firm's potential tier one instruments are eligible for inclusion in its permanent share capital; and

3. (3)

   rules defining whether a firm's potential tier one instruments must be classified as innovative tier one instruments.

The rules about redemption that are relevant to deciding whether a firm's potential tier one instruments are eligible for inclusion in its tier one capital resources at all are as follows.

1. (1)

   PRU 2.2.29 R (3) and PRU 2.2.39 R have the following provisions.

   1. (a)

      Any capital instrument that is redeemable at the option of the holder cannot form part of a firm's tier one capital resources. Instead, if it is redeemable at all, a capital instrument should only be redeemable at the option of the firm.

   2. (b)

      A redemption right should be exercisable no earlier than the fifth anniversary of the date of issue. However, if an instrument is an innovative tier one instrument which is subject to a step-up or any other economic incentive to redeem, any such redemption should be exercisable no earlier than the tenth anniversary.

   3. (c)

      Any redemption proceeds should be payable only in cash or in shares.

   4. (d)

      The terms of the capital instrument should provide that any redemption right should not be exercised unless and until the firm has given the notice to the FSA required under PRU 2.2.72 R.

   5. (e)

      Any redemption right should not be exercisable unless both before and after the redemption the firm complies with PRU 2.1.9 R (which requires that a firm has sufficient capital resources to meet its capital resources requirement).

2. (2)

   Under PRU 2.2.70 R, a firm should not include a potential tier one instrument that is redeemable in whole or in part in permanent share capital in its tier one capital resources unless the firm has:

   1. (a)

      sufficient permanent share capital or sufficient authority to issue permanent share capital (and the authority to allot it) to meet any redemption obligations that have become due; and

   2. (b)

      a prudent reserve of permanent share capital or sufficient authority to issue permanent share capital (and the authority to allot it) to meet possible future redemption obligations.

3. (3)

   PRU 2.2.65 R contains limits on the amount of permanent share capital that may be issued on a redemption of a potential tier one instrument redeemable in permanent share capital.

The rules defining whether a firm's potential tier one instruments are eligible for inclusion in its permanent share capital are to be found in PRU 2.2.36 R. As far as redemption is concerned, it says that the capital instrument should be no more capable of being redeemed than a share under the Companies Act 1985 or the Companies (Northern Ireland) Order 1986. PRU 2.2.38 R (which sets out the basic rules for redemption) does not apply to permanent share capital as a redeemable potential tier one instrument should not be included in permanent share capital.

The rules about redemption that are relevant to deciding whether a firm's potential tier one instruments should be classified as innovative tier one instruments are as follows.

1. (1)

   Under PRU 2.2.53 R, a redeemable potential tier one instrument is always treated as an innovative tier one instrument if the redemption proceeds are payable otherwise than in cash.

2. (2)

   Under PRU 2.2.54 R, any feature of a tier one instrument that in conjunction with a call would make a firm more likely to redeem it or to have an incentive to do so will make it an innovative tier one instrument.

3. (3)

   Under PRU 2.2.62 R a step-up coupled with a right of redemption results in a potential tier one instrument being treated as an innovative tier one instrument.

The rules in PRU 2.2 about the coupons payable on potential tier one instruments fall into the same three classes that apply to the rules on redemption, as set out in PRU 2.2.42 G.

The rules about coupons that are relevant to deciding whether a firm's potential tier one instruments are eligible for inclusion in its tier one capital resources at all are as follows.

1. (1)

   Under PRU 2.2.29 R (4) and PRU 2.2.40 R, any deferred cumulative coupon should only be payable in permanent share capital. If a cumulative coupon is payable on a potential tier one instrument in another form, it should not be included in the firm's tier one capital resources.

2. (2)

   Under PRU 2.2.29 R (7), the firm has the right not2 to pay a coupon in cash at any time.

3. (3)

   PRU 2.2.63 R says that a potential tier one instrument that may be subject to a step-up that potentially exceeds defined limits should not be included in the firm's tier one capital resources. PRU 2.2.64 R says that any step-up should not arise before the tenth anniversary of the date of issue if it is to be included in the firm's tier one capital resources.

4. (4)

   The provisions of PRU 2.2.70 R summarised in PRU 2.2.43 G (2) also apply to the payment of coupons.

PRU 2.2.36 R (2) says that a capital instrument on which a cumulative coupon is payable must not be included in a firm's permanent share capital. The payment of a coupon must be purely discretionary.2

The rules about coupons that are relevant to deciding whether a firm's potential tier one instruments should be classified as innovative tier one instruments are as follows:

1. (1)

   Under PRU 2.2.60 R a potential tier one instrument with a cumulative coupon is an innovative tier one instrument.

2. (2)

   Under PRU 2.2.40 R a potential tier one instrument with a coupon that if deferred must be paid in permanent share capital is an innovative tier one instrument.

3. (3)

   Under PRU 2.2.62 R a step-up coupled with a right of redemption by the firm results in a potential tier one instrument being treated as an innovative tier one instrument.

Perpetual non-cumulative preference shares should be perpetual and redeemable only at the firm's option. Any feature that, in conjunction with a call, would make a firm more likely to redeem perpetual non-cumulative preference shares would normally result in classification as an innovative tier one instrument. Such features would include, but not be limited to, a step-up, bonus coupon on redemption or redemption at a premium to the original issue price of the share.

Any feature that in conjunction with a call would make a firm more likely to redeem a tier one instrument would normally result in classification as innovative tier one capital resources. Innovative tier one instruments include but are not limited to those incorporating a step-up or principal stock settlement.

The effect of PRU 2.2.56 R is that if a potential tier one instrument does constitute a liability, this should only be the case when the firm is able to pay that liability but chooses not to do so. As tier one capital resources must be undated, this will generally only be relevant on a solvent winding up of the firm.

The holder should agree that the firm has no liability (including any contingent or prospective liability) to pay any amount to the extent to which that liability would cause the firm to become insolvent if it made the payment or to the extent that its liabilities exceed its assets or would do if the payment were made. The terms of the capital instrument should be such that the directors can continue to trade in the best interests of the senior creditors even if this prejudices the interests of the holders of the instrument.

An item of capital does not fall into PRU 2.2.60 R merely because a firm has come under an obligation to pay a particular coupon in permanent share capital where that obligation is the result of a voluntary election by the holder or the firm to be paid the coupon in that form. Thus, for example, if a shareholder of a firm is allowed to elect to be paid a dividend in the form of a conventional scrip dividend, that does not make the share into an innovative tier one instrument.

There may be examples of capital instruments that, although based on a standard form, contain structural features that make the rules in PRU 2.2 difficult to apply. In such circumstances, a firm may seek individual guidance on the application of those rules to the capital instrument in question. See SUP 9 for the process to be followed when seeking individual guidance.

Additions to and deductions from capital resources will arise from the application of asset and liability valuation and admissibility rules (see PRU 1.3, PRU 2.2.86 R and PRU 2 Annex 1R). Downward adjustments include discounting of technical provisions for general insurance business (which is optional for financial reporting but not permitted for regulatory valuation - see PRU 2.2.80 R to PRU 2.2.81 R) . Details of valuation differences relating to technical provisions and liability adjustments for long-term insurance business are set out in PRU 7.3. In particular, contingent loans or other arrangements which are not valued as a liability under PRU 7.3.79R (2) result in a positive valuation difference.

The FSA may request a firm to provide it with a copy of the external auditor's opinion on whether the interim profits are fairly stated.

Intangible assets include goodwill, capitalised development costs, brand names, trademarks and similar rights, and licences.

PRU 2.2.86 R does not apply to intangible assets which must be deducted from tier one capital resources under PRU 2.2.84 R.

The list of admissible assets has been drawn with the aim of excluding assets:

1. (1)

   for which a sufficiently objective and verifiable basis of valuation does not exist; or

2. (2)

   whose realisability cannot be relied upon with sufficient confidence; or

3. (3)

   whose nature presents an unacceptable custody risk; or

4. (4)

   the holding of which may give rise to significant liabilities or onerous duties.

For the purposes of PRU 2.2.89 R, investments must be valued at their accounting book value in accordance with PRU 1.3.5 R.

Related undertakings which are also insurance undertakings are not included in PRU 2.2.90 R because a firm that is a participating insurance undertaking is subject to the requirements of PRU 8.3.

The purpose of PRU 2.2.93 R is to achieve practical subordination of capital instruments if they are to qualify as capital resources to the liabilities a firm has to with-profits policyholders, including liabilities which arise from the regulatory duty to treat customers fairly in setting discretionary benefits. (Principle 6 (Customers' interests) requires a firm to pay due regard to the interests of its customers and treat them fairly.) It is not sufficient for a capital instrument to be subordinated to such liabilities only on winding up of the firm because such liabilities to policyholders may have been reduced by the inappropriate use of management discretion to enable funds to be applied in repaying subordinated capital instruments before winding up proceedings commence.

PRU 2.2.93 R is an additional requirement to all other rules in PRU 2.2 concerning the eligibility of a capital instrument to count as a component of a firm's capital resources. Subordinated debt instruments will be the main type of capital instrument to which this rule is relevant, including both upper tier two (undated) and lower tier two (dated) subordinated debt instruments. Subordinated debt instruments which are issued by a related undertaking are not intended to be covered by this rule and may be included in group capital resources as appropriate if the other eligibility criteria are met.

PRU 2.2.29 R (8) and PRU 2.2.108 R (10) contain provisions concerning the marketing of a capital instrument. In relation to a firm to which PRU 2.2.93 R applies, in order to comply with PRU 2.2.29 R (8) and PRU 2.2.108 R (10), it should draw to the attention of subscribers the risk that payments may be deferred or cancelled in order to operate the with-profits fund so as to give priority to the payment of discretionary benefits to with-profits policyholders.

1. (1)

   Upper tier two instruments must meet the requirements of PRU 2.2.101 R (3) which goes beyond the requirement in PRU 2.2.93 R (3) since it requires a firm to have the option to defer payments in all circumstances, not just if necessary to treat customers fairly. However, for lower tier two instruments, PRU 2.2.93 R (3) represents an additional requirement since a failure to pay amounts of interest or principal on a due date must not constitute an event of default under PRU 2.2.108 R (2) for firms carrying on with-profits insurance business.

2. (2)

   For firms which are realistic basis life firms compliance with PRU 2.2.93 R (3) would usually be achieved if the capital instrument provides that no amounts will be payable under it unless the firm's capital resources exceed its capital resources requirement. However, such firms should ensure that the terms of the capital instrument refer to FSA capital resources requirements in force from time to time, including the current realistic reserving requirements and are not restricted to former minimum capital requirements based only on the Insurance Directives' required minimum margin of solvency. For firms which are not realistic basis life firms, compliance with PRU 2.2.93 R (3) will probably require specific reference to be made to treating customers fairly in the terms of the capital instrument.

Tier two capital resources is split into upper and lower tiers. The principal distinction between upper and lower tier two capital is that perpetual instruments may be included in upper tier two capital whereas dated instruments, such as fixed term preference shares and dated subordinated debt, are included in lower tier two capital.

Tier two capital instruments are capital instruments that combine the features of debt and equity in that they are structured like debt, but exhibit some of the loss absorption and funding flexibility features of equity.

Examples of capital instruments which may be eligible to count in upper tier two capital resources include the following:

1. (1)

   perpetual cumulative preference shares;

2. (2)

   perpetual subordinated debt; and

3. (3)

   other instruments that have the same economic characteristics as (1) or (2).

The effect of PRU 2.2.103 R is that if an upper tier two instrument does constitute a liability, this should only be the case when the firm is able to pay that liability but chooses not to do so. As upper tier two capital resources must be undated, this will generally only be relevant on a solvent winding up of the firm.

For the purpose of PRU 2.2.103 R (2)(b) above, the holder should agree that the firm has no liability (including any contingent or prospective liability) to pay any amount to the extent to which that liability would cause the firm to become insolvent if it made the payment or to the extent that its liabilities exceed its assets or would do if the payment were made. The terms of the capital instrument should be such that the directors can continue to trade in the best interests of the senior creditors even if this prejudices the interests of the holders of the instrument.

Capital instruments that meet the general conditions described in PRU 2.2.108 R may be included in lower tier two capital resources.

For the purposes of PRU 2.2.108 R (5) the debt agreement or terms of the instrument should not contain any clause which might require early repayment of the debt (e.g. cross default clauses, negative pledges and restrictive covenants). A cross default clause is a clause which says that the loan goes into default if any of the borrower's other loans go into default. It is intended to prevent one creditor being repaid before other creditors, e.g. obtaining full repayment through the courts. A negative pledge is a clause which puts the loan into default if the borrower gives any further charge over its assets. A restrictive covenant is a term of contract that directly, or indirectly, could lead to early repayment of the debt. Some covenants, e.g. relating to the provision of management information or ownership restrictions, are likely to comply with PRU 2.2.108 R (5) as long as monetary redress is ruled out, or any payments are covered by the subordination and limitation of remedies clauses (that is, if damages are unpaid, the only remedy is to petition for a winding up).

The purpose of PRU 2.2.108 R (7) is to ensure that all of the firm's assets are available to customers ahead of subordinated creditors. The waiver should apply both before and during liquidation.

An item of capital does not comply with PRU 2.2.108 R (10) if it is marketed as a capital instrument that would only qualify for a lower level of capital or on the basis that investing in it is like investing in a lower tier capital instrument. For example, an undated capital instrument should not be marketed as a dated capital instrument if the terms of the capital instrument include an option by the issuer to redeem the capital instrument at a specified date in the future.

For the purposes of PRU 2.2.113 R, examples of connected transactions might include guarantees or any other side agreement provided to the holders of the capital instrument by the firm or a connected party or a related transaction designed, for example, to enhance their security or to achieve a tax benefit, but which may compromise the loss absorption capacity or permanence of the original capital item.

The FSA is more concerned that the subordination provisions listed in PRU 2.2.108 R should be effective than that they should follow a particular form. The FSA does not, therefore, prescribe that the loan agreement should be drawn up in a standard form.

Debt instruments containing embedded options, e.g. issues containing options for the interest rate after the step-up to be at a margin over the higher of two (or more) reference rates, or for the interest rate in the previous period to act as a floor, may affect the funding costs of the borrower and imply a step-up. In such circumstances, a firm may wish to seek individual guidance on the application of the rules relating to step-ups to the capital instrument in question. See SUP 9 for the process to be followed when seeking individual guidance.

PRU 2.2.124 R applies both to a tier two instrument with a fixed maturity and to a tier two instrument with no fixed maturity but where the firm has given five years' notice of repayment.

Unpaid share capital or, in the case of a mutual, unpaid initial funds and calls for supplementary contributions are excluded from the capital resources of a firm except to the extent allowed in a waiver under section 148 of the Act.

Subject to a waiver, under the Insurance Directives a maximum of one half of unpaid share capital or, in the case of a mutual, one half of the unpaid initial fund may be included in a firm's capital resources, once the paid-up part amounts to 25% of that share capital or fund, up to 50% of total capital resources.

In the case of a mutual carrying on general insurance business and subject to a waiver, calls for supplementary contributions within the financial year may only be included in a firm's capital resources up to a maximum of 50% of the difference between the maximum contributions and the contributions actually called in, subject to a limit of 50% of total capital resources. In the case of a mutual carrying on long-term insurance business, the Consolidated Life Directive does not permit calls for supplementary contributions to be included in a firm's capital resources.

Principle 4 requires a firm to maintain adequate financial resources. PRU 2 sets out provisions that deal specifically with the adequacy of that part of a firm's financial resources that consists of capital resources. The adequacy of a firm's capital resources needs to be assessed both by the firm and the FSA. In PRU 2.1, the FSA sets minimum capital resources requirements for firms. It also reviews a firm's own assessment of its capital needs, and the processes and systems by which that assessment is made, in order to see if the minimum capital resources requirements are appropriate. PRU 1.2 contains rules requiring a firm to identify and assess risks to its being able to meet its liabilities as they fall due, to assess how it intends to deal with those risks and to quantify the financial resources it considers necessary to mitigate those risks. To meet these requirements, a firm should consider the extent to which capital is an appropriate mitigant for the risks identified and assess the amount and quality of capital required. In accordance with PRU 1.2.37 R, these assessments must be documented so that they can be easily reviewed by the FSA as part of the FSA's assessment of the adequacy of the firm's capital resources.

This section (PRU 2.3) sets out guidance on how firms should assess the adequacy of their capital resources, both to comply with the rules in PRU 1.2 and to enable the FSA better to assess whether the minimum capital resources requirements in PRU 2.1 are appropriate. This section also requires firms carrying on general insurance business to calculate their ECR. 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 realistic basis life firms, the ECR forms part of the calculation of the firm's capital resources requirement (see PRU 2.1.15 R). The ECR for such firms requires the calculation of a with-profits insurance capital component (see PRU 7.4) that supplements the mathematical reserves so as to ensure that a firm holds adequate financial resources for the conduct of its with-profits insurance business. In the case of firms carrying on general insurance business and realistic basis life firms, the FSA will use the ECR as a benchmark for its consideration of the appropriateness of the firm's own capital assessment. For firms where an ECR is not calculated the MCR will provide a benchmark for the firm's own capital assessment. For firms generally, the more thorough, objective and prudent a firm's capital assessment is and can be demonstrated as being, the more reliance the FSA will be able to place on the results of that assessment. The FSA will consider the appropriateness of the firm's capital assessment to establish the level of capital resources the firm needs. This may result in the FSA's assessment of a firm's capital resources needs being lower or higher than would otherwise be the case.

There are two main purposes of this section:

1. (1)

   to enable firms to understand the issues which the FSA would expect to see assessed and the systems and processes which the FSA would expect to see in operation for capital adequacy assessments by the firm to be regarded as thorough, objective and prudent; and

2. (2)

   to enable firms to understand the FSA's approach to assessing whether the minimum capital resources requirements of PRU 2.1 are appropriate and what action may be taken if the FSA concludes that those requirements are not appropriate to a firm's circumstances.

In making an assessment of capital adequacy, the FSA requires firms to identify the major risks they face and, where capital is appropriate to mitigate those risks, to quantify how much (and what type) of capital is appropriate. To do this, the FSA expects firms to conduct stress tests and scenario analyses in respect of each risk. For each risk the firm will then be able to estimate a range of probable outcomes and hence capital required to absorb losses which might arise. A firm must document the results of each of the stress tests and scenario analyses undertaken and should also document, as part of the details of those tests and analyses, the key assumptions including the aggregation of the results.

The assessment which a firm makes should be based upon its future business plans and projections. This is the main area where the firm's assessment may diverge from its prescribed capital resources requirement which, necessarily, is based upon historic data.

In assessing the quality and the amount of capital resources projected to be available to meet its projected capital resources requirement, a firm should consider the timing of its liabilities to repay existing capital together with the prospects for raising new capital in the scenarios considered.

The FSA may ask for the results of a firm's assessment to be provided to it together with a description of the processes by which the assessment has been made, the range of results from each stress test or scenario analysis performed and the main assumptions made. The FSA may also carry out a more detailed examination of the details of the firm's processes and calculations.

Based upon this information and other information available to the FSA, the FSA will consider whether the capital resources requirement applicable to the firm is appropriate. Where relevant, the firm's ECR will be a key input to the FSA's assessment of the adequacy of the firm's capital resources.

Details of the calculation of the asset-related capital requirement are set out in PRU 3.3.10 R to PRU 3.3.16 R. 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.

Where the FSA considers that a firm will not comply with PRU 1.2.22 R (adequate financial resources, including capital resources) by holding the capital resources required by PRU 2.1, the FSA may give the firm individual guidance advising it of the amount and quality of capital resources which the FSA considers it needs to hold in order to meet that rule.

The individual guidance will be given taking into consideration capital resources consistent with a 99.5% confidence level over a one year timeframe or, if appropriate to the firm's business, an equivalent lower confidence level over a longer timeframe. Firms should therefore prepare an individual capital assessment on the same basis. Throughout whatever timeframe is adopted by firms, firms should ensure that their projected assets are, and will continue to be, sufficient, to enable their projected liabilities to be paid, and it would be reasonable for firms to test that this is the case at the end of each year of the timeframe. Firms may also wish to make estimates of capital adequacy using other assumptions for their own internal purposes and are free to do so if they so choose.

If a firm considers that the individual guidance is inappropriate to its circumstances, then the firm should inform the FSA that it does not intend to follow that guidance. Informing the FSA of such an intention would be expected if a firm is to comply with Principle 11 (relations with regulators).

The FSA expects most disagreements about the adequacy of capital will be resolved through further analysis and discussion. The FSA may consider the use of its powers under section 166 of the Act (Reports by skilled persons) to assist in such circumstances. If the FSA and the firm still do not agree on an adequate level of capital, then the FSA may consider using its powers under section 45 of the Act to, on its own initiative, vary a firm's Part IV permission so as to require it to hold capital in accordance with the FSA's view of the capital necessary to comply with PRU 1.2.22 R. SUP 7 provides further information about the FSA's powers under section 45.

Where a firm or the FSA considers that the capital resources requirements of PRU 2.1 require the holding of more capital than is needed for the firm to comply with PRU 1.2.22 R then the firm may apply to the FSA for a waiver of the requirements in PRU 2.1 under section 148 of the Act. This section sets out the factors which the FSA will consider in deciding whether to grant such a waiver request, and if so, the terms and extent of any modification to the rules in PRU 2.1. In addition to the statutory tests under section 148, these will include the thoroughness, objectivity, and prudence of a firm's own capital assessment and the extent to which the guidance in this section has been followed. The FSA will not grant a waiver that would cause a breach of the minimum capital requirements under the Insurance Directives.

PRU 1.2.35 R requires a firm to carry out stress tests and scenario analyses for each of the sources of risk identified in accordance with PRU 1.2.31 R. Using each of the risk categories set out in PRU 1.2.31 R, PRU 2.3.19 G to PRU 2.3.34 G set out the factors that a firm should consider. PRU 2 Ann 3 G provides a practical illustration of how a small firm carrying on general insurance business might undertake this analysis.

Credit risk refers to the risk of loss if another party fails to perform its obligations or fails to perform them in a timely fashion.

In assessing potential credit risk events that may affect the firm's solvency, a firm should allow for:

1. (1)

   the financial effect of non-payment of reinsurance, considering the likelihood both of non-payment of outstanding claims and for the fact that reinsurance cover purchased for underwritten risks may not be effective (that is, offsetting potential liabilities); and

2. (2)

   the financial effect of non-payment of premium debtors such as intermediaries and policyholders.

Some further areas to consider in developing the credit risk stress tests and scenario analyses might include:

1. (1)

   the adequacy of the reinsurance programme and whether it is appropriate for the risks selected by the firm and adequately takes account of the underwriting and business plans of the firm generally;

2. (2)

   the collapse of a reinsurer or several reinsurers on the firm'sreinsurance programme and the subsequent impact this may have on the firm's outstanding reinsurance recoveries and IBNR recoveries;

3. (3)

   a deterioration in the creditworthiness of the firm'sreinsurers, intermediaries or other counterparties;

4. (4)

   the degree of credit concentration. For example, the degree to which a firm is exposed to a single counterparty or group;

5. (5)

   the degree of concentration of exposure to reinsurers of particular rating grades;

6. (6)

   the prospect of reinsurance rates increasing substantially or reinsurance being unavailable;

7. (7)

   any existing or possible future disputes relating to reinsurance contracts on a pessimistic basis and the extent that they are not already reflected in the value attributed to the reinsurances;

8. (8)

   greater losses from bad debts than anticipated;

9. (9)

   deterioration in the extent and quality of collateral; and

10. (10)

    guarantees given by the insurer of the performance of others, whether under contracts of insurance or otherwise.

Market risk includes the risks that arise from fluctuations in values of, or income from, assets or in interest or exchange rates.

In assessing potential market risk events that may affect the firm's solvency, a firm should allow for:

1. (1)

   reduced market values of investments;

2. (2)

   variation in interest rates and the effect on the market value of investments;

3. (3)

   a lower level of investment income than planned; and

4. (4)

   the possibility of counterparty defaults.

Some further areas to consider in developing the market risk scenario might include:

1. (1)

   the possibility of a severe economic or market downturn or upturn leading to adverse interest rate movements affecting the firm's investment position;

2. (2)

   unanticipated losses and defaults of issuers;

3. (3)

   price shifts in asset classes, and their impact on the entire portfolio;

4. (4)

   inadequate valuation of assets;

5. (5)

   the direct impact on the portfolio of currency devaluation, as well as the effect on related markets and currencies;

6. (6)

   extent of any mismatch of assets and liabilities, including reinvestment risk;

7. (7)

   the impact on the portfolio value of a dramatic change in the spread between a market index of interest rates and the risk-free interest rates; and

8. (8)

   the extent to which market moves could have non-linear effects on values, such as derivatives.

In accordance with PRU 1.2.31 R a firm should consider the major sources of risk, including liquidity risks, and assess its response should each risk materialise.

PRU 5.1 (liquidity risk systems and controls) contains evidential provisions and guidance on how firms should meet PRU 1.2.22 R for liquidity purposes.

1. (1)

   PRU 5.1.61 E states that a scenario analysis in relation to liquidity risk required under PRU 1.2.35 R should include a cash-flow projection for each scenario tested, based on reasonable estimates of the impact of that scenario on the firm's funding needs and sources.

2. (2)

   PRU 5.1.86 E states that a firm should have a contingency funding plan for taking action to ensure, so far as it can, that in each of the scenarios tested under PRU 1.2.35R (2), it would still have sufficient liquid financial resources to meet liabilities as they fall due.

When assessing liquidity risk, the firm should consider the extent of mismatch between assets and liabilities and the amount of assets held in highly liquid, marketable forms should unexpected cashflows lead to a liquidity problem. The price concession of liquidating assets is a prime concern when assessing such liquidity risk and should be built into any assessment of capital adequacy.

Some further areas to consider in developing the liquidity risk scenario might include:

1. (1)

   any mismatching between expected asset and liability cash flows;

2. (2)

   the inability to sell assets quickly;

3. (3)

   the extent to which the firm's assets have been pledged;

4. (4)

   the cash-flow positions generally of the firm and its ability to withstand sharp, unexpected outflows of funds via claims, or an unexpected drop in the inflow of premiums; and

5. (5)

   the possible need to reduce large asset positions at different levels of market liquidity, and the related potential costs and timing constraints.

Operational risk refers to the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.

A firm may wish to refer to SYSC 3A and PRU 6.1 when carrying out its operational risk assessment.

Examples of some issues that a firm might want to consider include:

1. (1)

   the likelihood of fraudulent activity occurring that may impact upon the financial or operational aspects of the firm;

2. (2)

   the obligation a firm may have to fund a pension scheme for its employees;

3. (3)

   the technological risks that the firm may be exposed to regarding its operations. For example, risks relating to both the hardware systems and the software utilised to run those systems;

4. (4)

   the reputational risks to which the firm is exposed. For example, the impact on the firm if the firm's brand is damaged resulting in a loss of policyholders from the underwriting portfolio;

5. (5)

   the marketing and distribution risks that the firm may be exposed to. For example, the dependency on intermediary business or a firm's own sales force;

6. (6)

   the impact of legal risks. For example a non-insurance related legal action being pursued against the firm;

7. (7)

   the management of employees - for instance staff strikes, where dissatisfied staff may withdraw goodwill and may indulge in fraud or acts giving rise to reputational loss;

8. (8)

   the resourcing of key functions such as the risk management function by staff in appropriate numbers and with an appropriate mix of skills such as underwriting, claims handling, accounting, actuarial and legal expertise.

A firm may consider that investigation of operational weaknesses and corrective action is a better response than holding capital and may consider that a certain degree of operational risk is within its pre-defined risk tolerance. However, until the firm corrects any identified deficiencies a firm should consider capital as a (interim) response to the risk.

As a result of the differences between the nature of general and long-term insurance business, some aspects of the risk assessment vary depending on the type of business written. In assessing potential insurance risk events that may affect the firm's solvency, general and long-term insurance businessfirms should:

1. (1)

   analyse the potential for catastrophic losses, including both risk and event losses, the cost of reinstatement premiums and any possible reinsurance exhaustion; and

2. (2)

   determine the likelihood of any other feature of insurance risk that may lead to a variation in projected outcomes.

3. (3)

   Firms carrying on general insurance business should in addition:

   1. (a)

      analyse the potential for claims reserves to deteriorate beyond the current reserving level; and

   2. (b)

      determine the effect of loss ratios being higher than planned by analysing historic loss ratio experience and volatility.

4. (4)

   Firms carrying on long-term insurance business should in addition:

   1. (a)

      analyse the potential for mathematical reserves subsequently to prove inadequate compared with the current reserving level; and

   2. (b)

      determine the effect of claims experience being more costly than planned by analysing historic claims experience, volatility and trends in experience.

Some further areas to consider in developing the insurance risk scenario might include:

1. (1)

   For underwriting risks, general insurance business and long-term insurance business firms:

   1. (a)

      the adequacy of the firm's pricing. For example, the firm should be able to satisfy itself that it can charge adequate rates, taking into account the business and the risk profile of different products, the business environment (e.g. premium cycle-non-life) and its own internal profit targets;

   2. (b)

      the uncertainty of claims experience;

   3. (c)

      the dependence on intermediaries for a disproportionate share of the insurer's premium income; the effects of a high level of uncertainty in pricing in new or emerging underwriting markets due to a lack of information needed to enable the insurer to make a proper assessment of the price of the risk; the geographical mix of the portfolio or whether any geographical or jurisdictional concentrations exist;

   4. (d)

      the appropriateness of policy wordings;

   5. (e)

      the risk of mis-selling, for example, the number of complaints or disputed claims; and

   6. (f)

      the tolerance for expense reserve variations or variations in expenses (including indirect costs).

2. (2)

   For firms carrying on general insurance business, in addition:

   1. (a)

      the length of tail of the claims development and latent claims; and

   2. (b)

      the effects of rapid growth or decline in the volume of the underwriting portfolio.

3. (3)

   For firms carrying on long-term insurance business, in addition:

   1. (a)

      the uncertainty of future investment returns;

   2. (b)

      the effects of rapid growth or decline in the volume and nature of new business written; and

   3. (c)

      the ability of firms to adjust premium rates or charges for some products.

4. (4)

   For reserving and claims risks, both general insurance business and long term insurance business firms:

   1. (a)

      the frequency and size of large claims;

   2. (b)

      possible outcomes relating to any disputed claims, particularly where the outcome is subject to legal proceedings;

   3. (c)

      the ability of the firm to withstand catastrophic events, increases in unexpected exposures, latent claims or aggregation of claims;

   4. (d)

      the possible exhaustion of reinsurance arrangements, both on a per risk and per event basis;

   5. (e)

      social changes regarding an increase in the propensity to claim and to sue; and

   6. (f)

      other social, economic and technological changes.

5. (5)

   For firms carrying on general insurance business:

   1. (a)

      the adequacy and uncertainty of the technical claims provisions, such as outstanding claims, IBNR and claims handling expense reserves;

   2. (b)

      the adequacy of other underwriting provisions, such as the provisions for unearned premium and unexpired risk reserves;

   3. (c)

      the appropriateness of catastrophe models and underlying assumptions used, such as possible maximum loss (PML) factors used;

   4. (d)

      unanticipated legal judgements and legal change with retrospective effect specifically with regard to the claims reserves; and

   5. (e)

      the effects of inflation.

6. (6)

   For firms carrying on long-term insurance business:

   1. (a)

      the adequacy and sensitivity of the mathematical reserves to variations in future experience, including:

      1. (i)

         the risk that investment returns differ from those assumed in the reserving assumptions;

      2. (ii)

         the risk of variations in mortality, morbidity and persistency experience and in the exercise of options under contracts;

      3. (iii)

         the rates of taxation applied, in particular where there is uncertainty over the tax treatment; and

   2. (b)

      unanticipated legal judgements and legal change with retrospective effect specifically with regard to the impact on mathematical reserves.

Firms must assess the adequacy of their financial resources and this will entail an assessment of both capital resources and liquidity resources. The stress tests and scenario analyses which a firm must carry out will assist with both assessments. However, firms may also find it helpful to approach their assessment of capital in another way.

Firms may also wish to carry out an additional assessment to inform their view as to whether their capital resources are adequate. The additional assessment is to consider the extent to which the capital resources requirement (CRR) produces adequate capital for a firm's particular circumstances. In considering this, firms that are required to calculate an Enhanced Capital Requirement (ECR) may wish to note that the ECR as calculated is based upon the assumptions that a firm's business is well diversified, well managed with assets matching its liabilities and good controls, and stable with no large, unusual, or high risk transactions. Firms may find it helpful to assess the extent to which their actual business differs from these assumptions and therefore what adjustments it might be reasonable to make to the CRR or ECR to arrive at an adequate level of capital resources.

Firms may find it helpful for their own assessment process if they also consider divergences from the assumptions described in PRU 2.3.36 G under the headings set out below. These are the areas which the FSA considers when forming its view of the adequacy of a firm's capital resources.

Business risk factors:

(1) market risk;

(2) securitisation risk;

(3) residual risk;

(4) concentration risk;

(5) high impact, low probability events; and

(6) cyclicality and capital planning.

Control risk factors:

(1) systems and controls.

Market risk: a firm should assess its exposure to those elements of market risk that are not captured by the CRR. In doing so, firms may wish to use stress tests to determine the impact on their balance sheets of an appropriate move in market conditions. The results of this test should then be used by the firm to determine its market risk.

Securitisation risk: a firm should assess its exposure to risks transferred through the securitisation of assets should those transfers fail for whatever reason. For instance, firms may contemplate two broad types of securitisation: 'embedded value securitisation' - the transfer of the value emerging from an existing block of business to bondholders; and 'risk transfer securitisation' - the purchase of protection against catastrophic risks to the insurer through the issuance of bonds whose repayment is contingent upon the non-occurrence of such risks. In either case, firms should consider the effect on their financial position of a failure of such complex arrangements to operate as anticipated or the values and risks transferred not emerging as expected.

Residual risk: a firm should assess its exposure to the residual risks that may result from the partial performance or failure of risk mitigation techniques for reasons that are unconnected with their intrinsic value. This could result from (for example): ineffective documentation, a delay in payment or the inability to realise payment from a guarantor in a timely manner. Given that residual risks can always be present, firms should assess the appropriateness of their capital resources requirement against their assumptions for the risk mitigation measures that they may have in place.

Concentration risk: a firm should assess and monitor its exposure to: sector, geographic, liability and asset concentrations, as well as granularity. The FSA considers that concentrations in these areas increase the firm's credit risk and where the firm identifies concentrations then they should consider the adequacy of the capital resources requirement. For instance, firms should monitor concentrations of exposure to particular reinsurers and ensure that they are aware of the implications of several of their reinsurers failing at the same time.

High impact, low probability events: firms should consider stress tests and scenario analyses which are realistic - that is not too remote a possibility. However, should a firm decide to enter into a high impact, low probability transaction, the firm should satisfy itself that it has sufficient financial resources to meet its resulting financial obligation in the event the single risk materialises. For instance, a firm should not accept individual risks in circumstances where, if that single risk materialised, the claim arising would exceed the financial resources available to the firm.

A firm should also consider the value of the financial obligation arising where the risks from a combination of high impact, low probability transactions that the firm has entered into materialise at the same time. A firm should ensure that in no circumstances would a combination of any consequent claims materially exceed the financial resources available to it.

Cyclical and capital planning: a firm's capital resources requirement may vary as business cycles and economic conditions fluctuate over time. Firms should be aware that a deterioration in business or economic conditions could require them to raise capital or alternatively to contract their businesses at a time when market conditions are most unfavourable to raising capital. Such an effect is known as procyclicality.

To reduce the impact of cyclical effects, firms should look to build-up capital levels through the course of an upturn in business and economic cycles to ensure that they have sufficient capital available to protect themselves against adverse conditions.

To assess its expected capital requirements over the economic and business cycles, a firm may wish to project forward its financial position taking account of its business strategy and expected growth under a range of environmental assumptions. Projections over a three to five year period would be appropriate in most circumstances. Firms may then calculate their projected capital resources requirement and assess whether that requirement could be met from expected financial resources.

Systems and controls: a firm may decide to hold additional capital resources to mitigate weaknesses in its overall control environment. Weaknesses might be indicated by the following:

1. (1)

   a failure by the firm to complete an assessment of its systems and controls in line with SYSC 3.1 (Systems and Controls) and PRU 1.4;

2. (2)

   a failure by the firm's senior management to approve its financial results; and

3. (3)

   a failure by the firm to consider an analysis of relevant internal and external information on its business and control environment.

In considering any systems and control weaknesses and their effect on the adequacy of the capital resources requirement, a firm may wish to be able to demonstrate to the FSA that all the issues identified in SYSC 3.2 (Areas covered by systems and controls) have been considered; and that appropriate plans and procedures exist to deal adequately with adverse scenarios.

A firm may approach its assessment of adequate capital resources by developing a model for some or all of its business risks. Where such a model captures some of the risks identified in accordance with PRU 1.2.31 R then this will usually satisfy the requirement to perform stress tests in respect of those risks. However, the assumptions required to aggregate risks modelled and the confidence levels adopted should be considered by the firm's senior management. A firm should also consider whether any risks are not captured by the model and also the extent to which systems and control risks are not incorporated in the model.

A firm should not expect the FSA to accept as adequate any particular model that it develops or that the results from the model are automatically reflected in any individual guidance given to the firm for the purpose of determining adequate capital resources. However, the FSA will take into account the results of any sound and prudent model when giving individual guidance or considering applications for a waiver under section 148 of the Act of the capital resources requirement in PRU 2.1. This section sets out the types of issues the FSA would consider before giving individual guidance or granting a waiver based on the results of a model.

There is no prescribed modelling approach for how a firm develops its internal model. However, firms should be able to demonstrate:

1. (1)

   the extent of use of the internal capital model within the firm's capital management policy;

2. (2)

   that sound and appropriate risk-management techniques are employed and are embedded in the daily operations and financial resources requirements of the firm;

3. (3)

   that all material risks to which the firm is exposed have been adequately addressed by quantitative and qualitative means as appropriate;

4. (4)

   the confidence levels set and whether these are linked to the firm's corporate strategy;

5. (5)

   the time horizons set for the different types of business that the firm undertakes;

6. (6)

   the extent of historic data used and back testing carried out; and

7. (7)

   whether sufficient accuracy and validation in the internal capital model has been undertaken.

The firm's model should be based on an appropriate probability of insolvency over an appropriate time period. A firm should be able to demonstrate the selected probability of insolvency and time horizon it has derived and explain why these are appropriate for its business.

Good models will have as inputs (in addition to the specific examples given under the stress and scenario guidance):

For both firms carrying on general insurance business and long-term insurance business:

1. (1)

   assumed future investment returns. In particular, assumptions for future interest rates (to the extent that they impact on interest income on funds on deposit, price of and yield on fixed stock that may be purchased in future and interest income on variable interest rate assets), equity prices, dividend income, property prices, property rental income and inflation. The assumptions should take account of likely volatility and historic volatility in interest rates and asset prices;

2. (2)

   five-year predictions as to premium rates in each homogeneous category of business taking account of the effect of underwriting cycles;

3. (3)

   predictions of exposures written in each homogeneous category of business in the next five years;

4. (4)

   predictions of premium volume and expected growth under a five year business plan;

5. (5)

   expenses and commission;

6. (6)

   catastrophic events, aggregations of claims and claims affecting more than one class of business;

7. (7)

   inflation in terms of how it might affect future claims, non-settled claims that have occurred to date, future expenses, future reinsurance costs and future investment returns;

8. (8)

   reinsurance programmes in place, allowing for changing term conditions, reinstatements and loss experience features;

9. (9)

   estimates of non-recovery of reinsurance and other debtors taking account of the financial strength of each reinsurance or other counterparty; and

10. (10)

    foreign exchange movements.

For firms carrying on general insurance business in particular:

1. (11)

   frequency and severity of claims (including costs associated with claims such as professional fees) for each homogeneous category of business, allowing for any impact of future social, legal and inflationary effects (especially concerning price, earnings, medical and claims) on future claims costs;

2. (12)

   settlement patterns of claims and reinsurance recoveries for each homogeneous category of business (including occurred and future claims);

3. (13)

   unintended coverage of risks; and

4. (14)

   correlation between these risks.

For firms carrying on long-term insurance business in particular:

1. (15)

   projected claims experience for each homogeneous category of business allowing for trends in mortality/ morbidity experience;

2. (16)

   assumptions for future policyholder actions such as lapsing or surrendering a policy, ceasing to pay premiums or choosing to exercise an option under the contract; and

3. (17)

   for business where management has discretion over the level of benefits or charges, assumptions about management reactions to changes in economic conditions and consequent changes to the benefits or charges.

The FSA places credence in approaches to financial models to aid the assessment of capital adequacy which involve the production of a Dynamic Financial Analysis ("DFA") model. These models transform each element in the financial projection into a statistical distribution with a range of possible outcomes, and are therefore stochastic. They would generally incorporate a suitable economic model integrated into the DFA model and linked into the generation of insurance related assumptions. The model would, as far as possible, cover all risks and all areas of business. The future time period over which projections are made should be determined with reference to the type of insurance business written, the asset profile and the insurance cycle. It may be appropriate to consider several different time periods.

Due regard should also be given to the historical experience of both the firm and the wider relevant industry and market when assigning values to the above inputs.

The values assigned to each of the above inputs should be derived either stochastically, by assuming the value of an item can follow an appropriate probability distribution and by selecting appropriate values at the tail of the distribution, or deterministically, using appropriate prudent assumptions. For long-term insurance business which includes options or guarantees that change in value significantly in certain economic or demographic circumstances, a stochastic approach would normally be appropriate.