PRU 3.2 Credit risk in insurance

PRU 3.2 applies to an insurer unless it is:

1. (1)

   a non-directive friendly society; or

2. (2)

   an incoming EEA firm; or

3. (3)

   an incoming Treaty firm.

All of PRU 3.2, except PRU 3.2.20 R and PRU 3.2.23 R to PRU 3.2.32 G, applies to:

1. (1)

   an EEA-deposit insurer; and

2. (2)

   a Swiss general insurer;

but only in respect of the activities of the firm carried on from a branch in the United Kingdom.

1. (1)

   This section applies to a firm in relation to the whole of its business, except where a particular provision provides for a narrower scope.

2. (2)

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

Taking into account relevant risks, a firm must restrict its counterparty exposures and asset exposures to prudent levels and ensure that those exposures are adequately diversified.

1. (1)

   For the purposes of PRU 3.2, counterparty exposure is the amount a firm would lose if a counterparty were to fail to meet its obligations (either to the firm or to any other person) and if simultaneously securities issued or guaranteed by the counterparty were to become worthless.

2. (2)

   For the purposes of PRU 3.2, asset exposure is the amount a firm would lose if an asset or class of identical assets (whether or not held directly by the firm) were to become worthless.

3. (3)

   For the purposes of (1) and (2), the amount of loss is the amount, if any, by which the firm's capital resources (as calculated in accordance with PRU 2.2.14 R but without making any deduction for assets in excess of market risk and counterparty limits) would decrease as a result of the counterparty failing to meet its obligations and the securities or assets becoming worthless.

4. (4)

   In determining the amount of loss in accordance with (3), the firm must take into account decreases in its capital resources that would result not only from its own direct exposures but also from:

   1. (a)

      exposures held by any of its subsidiary undertakings; and

   2. (b)

      synthetic exposures arising from derivatives or quasi-derivatives held or entered into by the firm or any of its subsidiary undertakings.

5. (5)

   If a firm elects under PRU 3.2.35 R to make a deduction in respect of collateral, the firm must deduct from the amount of loss determined in accordance with (3) so much of the value of that collateral as:

   1. (a)

      would be realised by the firm were it to exercise its rights in relation to the collateral; and

   2. (b)

      does not exceed any of the relevant limits in PRU 3.2.22R (3).

For the purposes of PRU 3.2.8 R and of determining counterparty exposure and asset exposure in accordance with PRU 3.2.9 R and reinsurance exposure in accordance with PRU 3.2.25 R, a firm must only rely upon a loss mitigation technique where it has good reason to believe that, taking into account the possible circumstances of default, it is likely to be effective.

For the purposes of PRU 3.2.8 R and of determining counterparty exposure and asset exposure in accordance with PRU 3.2.9 R and reinsurance exposure in accordance with PRU 3.2.25 R, a firm must not rely upon preferential access to assets unless it has taken into account appropriate professional advice as to its effectiveness.

1. (1)

   A firm must take reasonable steps to limit its counterparty exposure or asset exposure to:

   1. (a)

      a single counterparty;

   2. (b)

      each of the counterparties within a group of closely related counterparties; and

   3. (c)

      an asset or class of identical assets;

   to a level where, if a total default were to occur, the firm would not become unable to meet its liabilities as they fall due.

2. (2)

   In (1), a total default occurs where:

   1. (a)

      the single counterparty or all of the counterparties within the group of closely related counterparties fail to meet its or their obligations and simultaneously any securities issued or guaranteed by it or any of them become worthless; or

   2. (b)

      the asset becomes worthless or all of the assets within the identical class become worthless at the same time.

3. (3)

   (1) does not apply to:

   1. (a)

      a reinsurance exposure; or

   2. (b)

      a counterparty exposure or asset exposure to an approved credit institution.

1. (1)

   A firm must calculate the amount of the deduction from total capital required by stage L in the Table in PRU 2.2.14 R in respect of assets in excess of market risk and counterparty limits as the aggregate amount by which its counterparty exposures and asset exposures exceed the relevant limits set out in (3).

2. (2)

   Except where the contrary is expressly stated in PRU, whenever:

   1. (a)

      a rule in PRU refers to assets of a firm, or of any part of a firm, or of any fund or part of a fund within a firm, which are assets of a kind referred to in any of the limits in (3); and

   2. (b)

      the firm's counterparty exposure (or aggregate exposure arising from the counterparty exposures to each member of a group of closely related persons) or asset exposure in respect of those assets exceeds any of the limits in (3);

the firm must deduct from the measure of the value of those assets (as determined in accordance with PRU 1.3) the amount by which that exposure exceeds the relevant limit in (3), or that portion of the deduction that relates to the part of the firm or fund or part of a fund in question.

1. (3)

   The limits referred to in (1) and (2) are the following, expressed as a percentage of the firm's business amount:

   1. (a)

      for a counterparty exposure to an individual, unincorporated body of individuals or the aggregate exposure arising from the counterparty exposures to each member of a group of closely related individuals or unincorporated bodies of individuals:

      1. (i)

         ¼% for that part of the exposure that arises from unsecured debt;

      2. (ii)

         1% for the whole exposure (after deduction of the excess arising from the limit in (a)(i));

   2. (b)

      for a counterparty exposure to an approved counterparty or the aggregate exposure arising from the counterparty exposures to each member of a group of closely related approved counterparties:

      1. (i)

         5% for that part of the exposure not arising from short term deposits made with an approved credit institution; this limit is increased to 10% if the total of exposures which are greater than 5% arising from applying a 10% limit does not exceed1 40%;

         1
      2. (ii)

         20% or £2 million if larger for the whole exposure (after deduction of the excess arising from the limit in (b)(i));

   3. (c)

      for a counterparty exposure to a person, or the aggregate exposure arising from the counterparty exposures to each member of a group of closely related persons, who do not fall into the categories of counterparty to whom (a) and (b) apply:

      1. (i)

         1% for that part of the exposure arising from unsecured debt; this limit is increased to 2.5% in the case of an exposure to a regulated institution;

      2. (ii)

         1% for that part of the exposure arising from shares and other variable yield participations1, bonds, debt securities and other money market instruments and capital market instruments from the same counterparty that are not dealt in on a regulated market, or any beneficial interest in a collective investment scheme which is not a UCITS scheme, a non-UCITS retail scheme or a recognised scheme; the limit for that part of the exposure arising from debt securities (other than hybrid securities) issued by the same regulated institution is increased to 5%;

      3. (iii)

         5% for the whole exposure (after deduction of the excesses arising from the limits in (c)(i) and (ii));

   4. (d)

      5% for the aggregate of all counterparty exposures that fall within (c)(i) whether or not they arise from persons who are closely related, but excluding amounts that are in excess of the limit in (c)(i);

   5. (e)

      10% for the aggregate of all counterparty exposures that fall within (c)(ii) whether or not they arise from persons who are closely related, but excluding amounts that are in excess of the limit in (c)(ii);

   6. (f)

      5% for the aggregate of all counterparty exposures arising from unsecured loans, other than those falling within (3)(b);

   7. (g)

      3% for the asset exposure arising from all cash in hand;

   8. (h)

      10% for the asset exposure (including an exposure arising from a reversionary interest) arising from any one piece of land or building, or a number of pieces of land or buildings close enough to each other to be considered effectively as one investment.

2. (4)

   In (3) a firm's business amount means the sum of:

   1. (a)

      the firm's total gross technical provisions;

   2. (b)

      the amount of its other liabilities (except those included in the calculation of capital resources in accordance with PRU 2.2.14 R); and

   3. (c)

      such amount as the firm may select not exceeding, in the case of a firm which is not a participating insurance undertaking,1 the amount of the firm's total capital after deductions as calculated at stage M of the calculation in PRU 2.2.14 R or, in the case of a firm which is a participating insurance undertaking, the amount calculated in accordance with (5A)1 or, in either case,1 if higher:

      1. (i)

         in the case of a firm carrying on general insurance business, the amount of its general insurance capital requirement; and

      2. (ii)

         in the case of a firm carrying on long-term insurance business, the amount of its long-term insurance capital requirement and the amount of its resilience capital requirement.

3. (5)

   For the purpose of (4)(a), a firm's total gross technical provisions exclude technical provisions in respect of index-linked liabilities or property-linked liabilities, except that where the linked long-term contract of insurance in question includes a guarantee of investment performance or some other guaranteed benefit, the total gross technical provisions include the technical provisions in respect of that guaranteed element.

4. (5A)

   For the purpose of (4)(c), a firm which is a participating insurance undertaking must calculate the amount of the firm's group capital resources less the difference between:1

   1. (a)

      the firm's group capital resources requirement; and1

   2. (b)

      the firm's capital resources requirement.1

5. (5B)

   In (3)(b)(i) short term deposit means a deposit which may be withdrawn at the discretion of the lender without penalty or loss of accrued interest by giving notice of withdrawal of one month or less.1

6. (6)

   In (3)(c)(ii) hybrid security means a debt security, other than an approved security, the terms of which provide, or have the effect that, the holder does not, or would not, have an unconditional entitlement to payment of interest and repayment of capital in full within 75 years of the date on which the security is being valued.

A firm must notify the FSA in accordance with SUP 15.7 as soon as it first becomes aware that:

1. (1)

   a reinsurance exposure to a reinsurer or group of closely related reinsurers is reasonably likely to exceed 100% of its capital resources; or

   1
2. (2)

   if (1) does not apply, that it has exceeded this limit.

Upon notification under PRU 3.2.23 R, a firm must:

1. (1)

   demonstrate that prudent provision has been made for the reinsurance exposure in excess of the 100% limit, or explain why in the opinion of the firm no provision is required; and

2. (2)

   explain how the reinsurance exposure is being safely managed.

1. (1)

   For the purposes of PRU 3.2, a reinsurance exposure is the amount of loss which a firm would suffer if a reinsurer or group of closely related reinsurers were to fail to meet its or their obligations under contracts of reinsurance reinsuring any of the firm's contracts of insurance.

2. (2)

   For the purposes of (1), the amount of loss is the amount, if any, by which the firm's capital resources (as calculated in accordance with PRU 2.2.14 R but without making any deduction for assets in excess of market risk and counterparty limits) would decrease as a result of the reinsurer or group of closely related reinsurers failing to meet its or their obligations under the contracts of reinsurance.

3. (3)

   If a firm elects under PRU 3.2.35 R to make a deduction in respect of collateral, the firm must deduct from the amount of loss determined in accordance with (2) so much of the value of that collateral as:

   1. (a)

      would be realised by the firm were it to exercise its rights in relation to the collateral; and

   2. (b)

      does not exceed any of the relevant limits in PRU 3.2.22R (3).

A firm must, in determining its reinsurance exposures for the purposes of PRU 3.2, aggregate any reinsurance exposure where the identity of the reinsurer is not known by the firm with the highest reinsurance exposure where it does know the identity of the reinsurer.

A firm must notify the FSA immediately in accordance with SUP 15.7 if it has exceeded, or anticipates exceeding, the limit expressed in PRU 3.2.28 E.

Upon notification under PRU 3.2.29 R, a firm must explain to the FSA how, despite the excess reinsurance concentration, the credit risk is being safely managed.

In PRU 3.2.20 R and PRU 3.2.22 R, references to a counterparty exposure or an asset exposure do not include such an exposure arising from:

1. (1)

   [deleted]1

   1
2. (2)

   premium debts;

3. (3)

   advances secured on, and not exceeding the surrender value of, long-term insurance contracts of the firm;

4. (4)

   rights of salvage or subrogation;

5. (5)

   deferred acquisition costs;

6. (6)

   assets held to cover index-linked liabilities or property-linked liabilities, except that where the linked long-term contract of insurance in question includes a guarantee of investment performance or some other guaranteed benefit, PRU 3.2.20 R and PRU 3.2.22 R will nevertheless apply to assets held to cover that guaranteed element;

7. (7)

   moneys due from, or guaranteed by, a Zone A country;

8. (8)

   an approved security;

9. (9)

   a holding in a collective investment scheme falling within the UCITS Directive1.

In PRU 3.2.22 R references to a counterparty exposure or an asset exposure do not include such an exposure arising from reinsurance debts and the reinsurer's share of technical provisions.

If:

1. (1)

   a firm has a counterparty exposure, an asset exposure or a reinsurance exposure in respect of which it has rights over collateral (except where that collateral is a letter of credit - see PRU 3.2.36 R and PRU 3.2.37 R)1; and

2. (2)

   the assets constituting that collateral would, if owned by the firm, be admissible assets;

the firm may, in determining the amount of that exposure, deduct the value of that collateral in accordance with PRU 3.2.9R (5) or, in the case of a reinsurance exposure, PRU 3.2.25R (3).

If a firm has a counterparty exposure, asset exposure or reinsurance exposure the whole or any part of which is:

1. (1)

   guaranteed by a credit institution or an investment firm subject in either case to the Capital Adequacy Directive or supervision by a third country (non-EEA) supervisory authority with a Capital Adequacy Directive-equivalent regime; or

2. (2)

   adequately mitigated by a credit derivative;

the firm may, for the purposes of PRU 3.2.20 R, PRU 3.2.22 R and PRU 3.2.23 R, treat that exposure, or that part of the exposure which is so guaranteed or mitigated, as an exposure to the guarantor or derivative counterparty, rather than to the original counterparty, asset or reinsurer.

For the purposes of PRU 3.2.36 R, references to an exposure being guaranteed include an exposure secured by a letter of credit, but to fall within PRU 3.2.36 R the guarantee or letter of credit must be direct, explicit, unconditional and irrevocable.

For the purposes of PRU 3.2.20 R and PRU 3.2.22 R, a UCITS scheme, a non-UCITS retail scheme, a recognised scheme or any other collective investment scheme that invests only in admissible assets (including any derivatives or quasi-derivatives held by the scheme) is to be treated as closely related to the issuer of the units in that scheme.

For the purposes of PRU 3.2, a group of persons is closely related if it consists solely of two or more natural or legal persons who, unless it is shown otherwise, constitute a single risk because as between any two of them one or other of the following relationships apply:

1. (1)

   one of them, directly or indirectly, has control, as defined in PRU 3.2.41 R, over the other or they are both controlled by the same third party; or

2. (2)

   there is no relationship of control as defined in PRU 3.2.41 R but they are to be regarded as constituting a single risk because they are so interconnected that, if one of them were to experience financial problems, the other would be likely to encounter repayment difficulties.

For the purposes of PRU 3.2.40 R, control means the relationship between a parent undertaking and a subsidiary undertaking, as defined in Article 1 of the Consolidated Accounts Directive (83/349/EEC), or a similar relationship between any natural or legal person and an undertaking.