PRU 2 Annex 3

A1

This annex provides an illustrative qualitative example of how a small firm could undertake its stress and scenario analysis without this being disproportionate to the size and complexity of its business so as to comply with PRU 1.2.35 R. For these reasons, the example does not provide any quantitative guidance as we believe this would be impractical given the diverse nature of each firm's individual circumstances.

A2

This example is based on guidance contained in PRU 2.3. The areas discussed are not exhaustive and it is likely that in practice a firm will need to consider a range of other issues.

A3

The scenarios that the firm generates as part of its analysis should aim to reflect the degree of risk in a variety of areas. How extreme these scenarios are will influence the ultimate level of capital required by the firm. The firm should not necessarily develop scenarios based on the current trading or economic conditions, but on possible trading or economic conditions that could occur during the next three to five years.

A4

In addition to examining its event scenarios, a firm should also be able to meet any individual risk (however unlikely) that it has accepted (or proposes to accept through its business plan) from policyholders. It therefore should analyse its exposures and ensure that it has sufficient capital or available reinsurance to cover its largest individual risks and accumulations.

Worked example

Background

A5

The firm used for this example is an insurer carrying on general insurance business within a large group, writing predominantly personal lines, household and motor policies of approximately £25m gross written premium. This business has a reasonable geographical spread, sourced significantly from within the United Kingdom. The firm has purchased appropriate reinsurance cover from a variety of reinsurers and has a demonstrated record of utilising this cover. Its settlement pattern for claims averages three years, however, there is a small element of the account with longer tail liability claims. The firm's investments and IT support are outsourced.

Insurance risk

A6

The risk of incorrect or inaccurate pricing of business over the scenario period can be addressed by examining typical uncertainties within the pricing basis and the volatility of claims experience.

A7

In examining the adequacy of its pricing, the firm establishes its underwriting and claims trend over a ten-year base period by reviewing profit and loss accounts (particularly underwriting profit). In particular it examines the following:

(i)

the volatility of losses in a particular line of business;

(ii)

whether the loss ratio exceeded 100% in any line of business; and

(iii)

whether the deferred acquisition cost (DAC) amount had been written down; e.g. whether an unexpired risk provision (URP) was necessary.

A8

The firm also examines whether its premiums over the last ten years have been:

(i)

reasonably stable;

(ii)

responsive enough to changes in claim exposures (so that profitability is maintained);

(iii)

providing adequately for contingencies (such as major losses e.g. hail, earthquake etc);

(iv)

encouraged loss control (through the use of deductibles, no claim bonuses etc);

A9

The firm also reviews its method of pricing. The firm considers and performs the following:

(i)

a review of acceptable rates, e.g. premiums being charged by competitors for similar products;

(ii)

an examination of whether there have been any difficulties in the past with delegated authorities in relation to pricing including the ability and experience of staff members setting or recommending premium prices;

(iii)

an examination of whether the firm has the appropriate mechanisms in place regarding premium rate changes (that is, who makes these decisions, frequency, and on what basis?); and

(iv)

a benchmark price assessment (e.g. the ability to provide adequate competitive premium rates). For example, indicative rates being determined through the use of industry statistics, competitor statistics and the firm's own analysis for all classes.

A10

Other factors the firm considers are:

(i)

changes in environment (e.g. legislation, social, economic etc);

(ii)

changes in policy conditions and deductibles; and

(iii)

impact of market segments (e.g. the effects of different claim frequencies and costs impacting the price charged).

A11

Having completed its analysis, the firm makes the following assumptions to define its underwriting risk:

(i)

claims costs. The firm assumes these are X% higher than in the premium basis;

(ii)

claims inflation. The firm assumes a X% claims inflation over the scenario period, compared to Y% in the pricing basis;

(iii)

policy expenses (fixed and variable) are X% higher than anticipated in the pricing basis;

(iv)

reinsurance charges are X% higher than anticipated in the pricing basis; and

(v)

investment income is X% lower than anticipated in the pricing basis.

As a result of the above analysis on a per risk basis, the firm considers that capital of between £X and £Y would cover the possibility of material deviations to projected results.

Allowing for catastrophes

A12

The allowance for catastrophic events within the insurance risk scenario should reflect both the severity and the frequency of these events.

A13

After considering the catastrophe reinsurance programme it may be clear that the upper limit is set at a level unlikely to be breached e.g. a 1 in 200 year event. Thus, for the purposes of the capital assessment, it would not be necessary to assume losses in excess of this retention.

A14

However, it may be determined that there is possible exhaustion of free reinstatements or of horizontal cover in total. For example, if there were a significant chance of three catastrophic losses in any one period but the reinsurance allowed only one free reinstatement, then the assessment may be to hold two retentions and the entire gross loss for the third event.

As a result of the above analysis, the firm considers it appropriate to hold capital sufficient to absorb three catastrophic losses: one European windstorm of £X, one UK flood of £Y, and one large man made explosion of £Z.

The reinsurance structure in place allows for X number of reinstatements at full premium.

Deterioration of reserves

A15

The firm considers the adequacy of its claims reserves by focussing on the liability valuation.

A16

The liability valuation may contain a range of answers that might indicate possible reserve variability. Also, the valuation will contain areas where judgement has been applied and assumptions formulated which are subjective. These areas are considered and stressed as appropriate.

A17

The firm also reviews the historic level of claims reserves and subsequent level of settlements to help determine the size of any historic levels of under and over reserving.

A18

Reinsurance arrangements are considered and the extent to which these arrangements protect against reserve deterioration is assessed.

A19

For unearned premium, where losses have yet to occur, the firm considers that the level of uncertainty is greater and considers similar factors to those relating to underwriting risk in addition to those discussed above.

As a result of the above analysis, the firm considers it appropriate to apply a X% loading to the outstanding claims provision, a Y% loading to the unearned premium provision and Z% to all other liability values. The firm considers that capital of between £X and £Y would adequately cover reserve deterioration.

Credit risk

A20

Credit risk relates to the risk of default by counterparties. The firm believes its exposure to credit risk results from financial transactions with counterparties including issuers, debtors, borrowers, brokers, policyholders, reinsurers and guarantors.

A21

When assessing credit risk the firm makes an assessment of the creditworthiness of counterparties to the assets of the firm.

A22

The assessment includes an evaluation of the credit risk associated with loans and investment portfolios; the quality of on and off balance sheet assets; the ongoing management of the loans and investment portfolios; as well as loss provisions and reserves.

A23

The firm believes its exposure to credit risk also arises due to its exposure to its reinsurers. In this regard, the firm uses the credit ratings assigned to particular counterparties as a measure of credit risk, most notably Standard & Poor's, Moody's Investors Service and AM Best's (particularly for reinsurers).

A24

When forming an opinion on credit risk the firm considers:

Reinsurance

A25

The firm's strategy is to lessen exposure to a single lead reinsurer to less than 30%, with other participants holding no more than 15%. In all cases, the panel of reinsurers all have a specified rating. The firm has no prior experience of disputes, and their working relationship with the panel may be excellent, and thus the firm does not envisage any future difficulties arising in this regard.

A26

Bond default rates could then be used to assess a likely credit risk figure for reinsurance recoveries (including IBNR recoveries).

The firm considers that capital of between £X and £Y would cover reinsurance defaults, with no additional allowance for disputes.

Overseas financial institutions and banks

A27

The firm investigates its business relationships with overseas financial institution counterparties including banks, and decides no additional allowance is required.

Quality of counterparties and trends in counterparty risk

A28

The firm assesses the level and age of debtors, focussing particularly upon unpaid premiums, especially those greater than three months old, and reviews the level and trend of contingent liabilities. For example, the firm estimates that the credit risk scenario equates to taking a 10% reduction in the asset value of debtors, based on bond default rates and age of debt.

The firm considers that capital of between £X and £Y would cover credit risk to counterparties.

Off-balance sheet transactions

A29

The firm investigates any unfunded commitments, credit derivatives, commercial or standby letters of credit. Where these exist the possibility of a loss on these instruments is considered in relation to the requirement of the credit risk scenario.

The firm considers that no additional capital is necessary.

Market risk

A30

Market risk encompasses an adverse movement in the value of the assets as a consequence of market movements such as interest rates, foreign exchange rates, equity prices, etc. which is not matched by a corresponding movement in the value of the liabilities.

A31

In examining possible market risks, the firm considers its sensitivity to market risk by evaluating the degree to which changes in interest rates, foreign exchange rates, equity prices, or other areas can adversely affect the firm's earnings or capital.

A32

The firm believes its assets and liabilities are approximately matched e.g. there is no existence of large unmatched or unhedged currency positions; short tail business is backed by cash/fixed interest assets of suitable term and long tail business with real assets e.g. shares/property. If mismatching does exist this should be allowed for within the estimate.

A33

In developing the scenario the firm estimates the effect of a X% increase in interest rates on bond values.

A34

Similarly, the firm estimates the effect on equity values of a major recession to estimate the possible reduction in the value of equity capital. Also, it uses a suitable equity index to determine the size of historical falls in equity values and indicate possible future falls.

A35

Counterparty risk might be allowed for by assuming one or several major corporate bond holding defaults.

A36

For all investments, the stability of trading revenues should be examined to determine the volatility of investment.

From the above analysis, the firm considers that capital of between £X and £Y would be appropriate to protect it against adverse movement in market risk.

Liquidity risk

A37

Liquidity risk is the potential that the firm may be unable to meet its obligations as they fall due as a consequence of having a timing mismatch. The firm considers liquidity risk relates to the risk associated with the processes of managing timing relationship between asset and liability cash flow patterns.

A38

When assessing liquidity risk, the firm considers the extent of mismatch between assets and liabilities and the amount of assets held in a highly liquid, marketable form should unexpected cashflows lead to a liquidity crunch.

A39

The price concession of liquidating assets is a prime concern when assessing liquidity risk and is built into the scenario.

A40

In examining the liquidity risk, the firm examines the following:

Marketability, quality and liquidity of assets

A41

The firm considers the assets held and makes an assessment regarding the quality and liquidity of these assets. Even though the assets matched the liabilities, residual risk remains given that timings are uncertain and there is a possibility that assets will be realised at unfavourable times. This is allowed for by assuming a 2.5% reduction in the market value of assets at realisation compared to the current market value.

The firm considers that capital of between £X and £Y would cover timing risk to counterparties.

Reliance on new business income

A42

The firm relies partially upon new business cash flows to meet current liabilities as they fall due. The firm analyses the sensitivity of future cash flow projections and new business assumptions and considers the effect of a reduced level of new business.

A43

The firm finds that it did not have immediate alternatives in place in case these expected new business cash flows were reduced. In this regard, it considers that these sources should be stressed by X%.

The firm considers that capital of between £X and £Y would cover possible effects of adjusting the asset portfolio to switch to more liquid assets.

A44

The firm also examines the volatility and cost of on- and off-balance sheet funding sources. The firm is satisfied that no concerns need to be raised and that there should not be any impact on its liquidity position.

A45

The firm believes it is well placed to manage unplanned changes in funding sources as well as react to changes in market conditions that affect its ability to quickly liquidate assets with minimal loss. The firm assesses that it has reasonable access to money markets and other sources of funding such as lines of credit.

A46

The firm has no previous problems or delays in meeting obligations (or accessing external funding).

Overall, from the above analysis, the firm considers that capital of between £X and £Y would be necessary to withstand the effects of deterioration in liquidity.

Governance Risk

A47

Governance risk relates to the risk associated with the board and/or senior management of the firm not effectively performing their respective roles.

A48

The existence and level of directors and officers insurance in place is investigated compared to known incidence of claims of this type.

A49

The firm assesses whether the current level of governance is appropriate for the firm, and the likelihood that the firm's practices may result in the board and/or senior management not adequately undertaking their roles. The cost of altering and strengthening the current board structure is considered.

A50

In this regard, the firm makes an assessment that it may be reliant on only a few senior executives, and may be exposed if they experience any misadventure.

The firm considers that capital of between £X and £Y would cover governance risk.

Strategic Risk

A51

Strategic risk arises from an inability to implement appropriate business plans and strategies, make decisions, allocate resources or adapt to changes in the business environment.

A52

The firm therefore assesses the prudence and appropriateness of its business strategy in the context of the firm's competitive and economic environment. In particular the assumptions, forecasting and projections are assessed considering the possibility of a fundamental market change due, for example, to higher numbers of competitors, changes in sales channels, new forms of insurance or changes in legislation. This review includes whether the reinsurance programme is appropriate for the risks selected by the firm and whether it adequately takes account of the underwriting and business plans of the firm generally.

A53

The firm considers the likelihood of a fundamental strategic shift too remote to include within the scenario given the maturity of the market in which they operate.

Operational risks

A54

In reviewing the operational risk exposures, the firm has examined its administration, compliance, event, fraud, governance, strategic and technological risks.

Administration

A55

The firm considers the risk of error or failure associated with the administrative aspects of the operation of its business. In this regard, the firm considers likelihood of financial loss and reputation harm due to failure or errors occurring and the likely size of these losses.

A56

None of the firm's administration is out-sourced to service providers.

A57

In undertaking the assessment, the firm considers the history of failure or error from transaction processing or control within the firm. Exception reports are produced on a quarterly basis. Past reports highlighted past administrative deficiencies. The biggest event in the past 10 years related to a situation where claim-handling staff shared access codes to the claims administration system. This resulted in an overpayment to some clients.

A58

The firm also examines the nature and extent of centralised and decentralised functions within the firm. Three branches report regularly to the central office and an appropriate system is in place to record financial information, handle complaints etc.

A59

The firm also reviews the segregation of duties between staff. It is satisfied that an adequate segregation of duties between underwriting claims and payments divisions exist in terms of acceptance, authorisation and payments. It is also satisfied that sufficient interaction between the front, middle and back offices exist in terms of financial control and risk management. For example, it is confident that its guidelines for accepting risks are adequate and that any breach would be picked up by exception reporting.

A60

The firm also investigates the level of staff expertise and training to administer its product range/services.

The firm considers that capital of between £X and £Y would cover the risk of future administration issues.

Compliance Risk

A61

The firm believes its main compliance risk relates to the risk of non-adherence to legislative and internal firm requirements.

A62

An investigation into compliance over the last 10 years finds no history of non-compliance with firm policy and control systems nor have there been any reported areas of non-compliance with legislation or other requirements.

A63

Regulatory reforms including corporate and consumer law are considered and it is assumed that expenses costs will rise as a result of developments in the next 5 years. As a result an additional X% of premium income was assumed for the expense ratio.

The firm considers that capital of between £X and £Y would cover the risk of future compliance issues.

Event risk

A64

Event risk relates to risks associated with the potential impact of significant events (e.g., financial system crisis, major change in fiscal system, natural disaster) on the operations of the firm.

A65

The definition of event risk is not intended to cover events that are directly associated with products and services offered, for example, events which may directly impact on the general insurance business.

A66

The firm concludes that no additional specific allocation is required.

Fraud Risk

A67

Fraud risk relates to the risk associated with intentional misappropriation of funds, undertaken with the objective of personal benefit at the expense of the firm.

A68

In assessing fraud risk, the firm considers the possibility of fraudulent acts occurring within the firm and the extent of controls which management has established to mitigate such acts.

A69

The firm examines fraud issues over a period of 10 years and finds one major incident where it was subject to a fraudulent activity. This involved fraudulent payments being made by a member of staff which resulted in a loss for the firm of £Xm. Based on this previous incident and allowing for improvements in controls, the company assessed a financial figure that it believes is consistent with the probability for this scenario.

The firm considers that capital of between £X and £Y would cover the risk of future fraud.

Technology Risk

A70

The firm considers the risk of error or failure associated with the technological aspects (IT systems) of its operations. Specifically, technology risk refers to both the hardware systems and the software utilised to run those systems.

A71

In relation to the firm's information systems, the firm assesses the past reliability and future functionality and believes them to be adequate. It does not have any future plans to either replace its systems or make major systems modifications.

A72

Concerning business continuity management and disaster recovery planning (and testing of plans), the firm reviews these plans regularly and tests them quarterly. A full back-up site exists with full recovery capabilities. Costs associated with utilising the site and associated business interruption insurance was estimated.

The firm considers that capital of between £X and £Y would cover technology risk.

Group risk

A73

The size of the group risk element within operational risk will depend on the ownership structure of the firm and how it is funded by the parent.

A74

The firm considers the likelihood and financial consequences of both insolvency and credit downgrading of its parent. Given the firm shares the parent's name there is a large risk of association.

A75

The firm considers it within the scope of the scenario to allow for a single downgrade of the parent's credit rating from AA to A. It does not believe the chance of insolvency great enough to allow for directly.

A76

The firm estimates the effect on its business plan and profit margins of the downgrade. It estimates the amount of business lost and the increase in marketing costs required to maintain the client base. It also allows for a change in the pricing basis to incorporate a reduced profit margin (with knock on impacts on the business volume and loss ratios).

From the above analysis, the firm considers that capital of between £X and £Y would be required to cover group risks.

Overall assessment

A77

After individually assessing each risk area, the firm considers the capital that it has estimated might be absorbed under each scenario. In aggregate the range of capital absorbed is between £X and £Y. It considers how many of these scenarios might reasonably occur within a period and the extent to which it could replace capital within that period. It takes into account scenarios which might reasonably be linked, the difficulty with which capital might be replaced if the scenarios occurred, and the changes in strategy which might need to be adopted if the scenarios occurred.

A78

The firm decides that the worst realistic combination of circumstances that might arise would absorb capital of between £A and £B.