PRU 4.3 Derivatives in insurance
Application
This section applies to an insurer, unless it is:
- (1)
- (2)
an incoming EEA firm; or
- (3)
The scope of application of PRU 4.3 is not restricted to firms that are subject to the relevant EC directives. It applies, for example, to pure reinsurers.
- (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)
Where a firm carries on both long-term insurance business and general insurance business, this section applies separately to each type of business.
Purpose
PRU 2.2.12 R requires a firm to calculate its capital resources for the purpose of PRU in accordance with Table PRU 2.2.14 R, subject to the limits in PRU 2.2.16 R to PRU 2.2.26 R. Table PRU 2.2.14 R and PRU 2.2.86 R require a firm to deduct from total capital resources the value of any asset included in an insurance fund which is not an admissible asset as listed in PRU 2 Annex 1R.PRU 2 Annex 1R provides that a derivative, quasi-derivative or stock lending transaction will only be an admissible asset if it is approved. This section sets out the criteria for determining when a derivative, quasi-derivative or stock lending transaction is approved for this purpose. PRU 4.3.5 R to PRU 4.3.35 R set out the criteria for derivatives and quasi-derivatives. PRU 4.3.36 R to PRU 4.3.41 R set out the criteria for stock lending transactions.
Derivatives and quasi-derivatives
For the purpose of PRU 2 Annex 1R(Admissible assets in insurance), a derivative or quasi-derivative is approved if:
- (1)
it is held for the purpose of efficient portfolio management (PRU 4.3.6 R to PRU 4.3.7 R) or reduction of investment risk (PRU 4.3.8 R to PRU 4.3.13 G);
- (2)
it is covered (PRU 4.3.14 R to PRU 4.3.33 G); and
- (3)
it is effected or issued:
- (a)
on or under the rules of a regulated market; or
- (b)
off-market with an approved counterparty and, except for a forward transaction, on approved terms and is capable of valuation (PRU 4.3.34 R to PRU 4.3.35 R).
- (a)
Efficient portfolio management
A derivative or quasi-derivative is held for the purpose of efficient portfolio management if the firm reasonably believes the derivative or quasi-derivative (either alone or together with any other covered transactions) enables the firm to achieve its investment objectives by one of the following:
- (1)
generating additional capital or income in one of the ways described in PRU 4.3.7 R; or
- (2)
reducing tax or investment cost in relation to admissible assets; or
- (3)
acquiring or disposing of rights in relation to admissible assets, or their equivalent, more efficiently or effectively.
Generation of additional capital or income
The generation of additional capital or income falls within PRU 4.3.6 R (1) where it arises from:
- (1)
taking advantage of pricing imperfections in relation to the acquisition and disposal (or disposal and acquisition) of rights in relation to assets the same as, or equivalent to, admissible assets; or
- (2)
receiving a premium for selling a covered call option or its equivalent, the underlying of which is an admissible asset, even if that additional capital or income is obtained at the expense of surrendering the chance of greater capital or income.
Reduction of investment risk
A derivative or quasi-derivative is held for the purpose of reducing investment risk if the derivative or quasi-derivative (either alone or together with other fully covered transactions) reduces any aspect of investment risk without significantly increasing any other aspect of that risk.
Significant increase in risk
For the purposes of PRU 4.3.8 R, an increase in risk from a derivative or quasi-derivative is significant unless:
PRU 4.3.8 R does not require that a derivative or quasi-derivative has no possible adverse consequences. Often a derivative or quasi-derivative is effected to protect against a severe adverse consequence that only arises in one circumstance. In all other circumstances it may itself lead to adverse consequences, even if only because it expires worthless resulting in the loss of the purchase price. Conversely a derivative or quasi-derivative may reduce risk in a wide range of circumstances but lead to adverse consequences when a particular circumstance arises, e.g. the default of the counterparty. Only rarely does a derivative or quasi-derivative give rise to no adverse consequences in any circumstances. The test is merely that the increase in risk should not be significant, that is it should be both small and reasonable, or the risk should be remote.
Investment risk
For the purposes of PRU 4.3.8 R, investment risk is the risk that the assets held by a firm:
- (1)
(where they are admissible assets held by the firm to cover its technical provisions) might not be:
- (a)
of a value at least equal to the amount of those technical provisions as required by PRU 7.2.20 R; or
- (b)
of appropriate safety, yield and marketability as required by PRU 7.2.34R (1)(a); or
- (c)
of an appropriate currency match as required by PRU 4.2.53 R;
- (a)
- (2)
(where they are held to cover index-linked liabilities) might not be appropriate cover for those liabilities as required by PRU 4.2.58 R; and
- (3)
(where they are held to cover property-linked liabilities) might not be appropriately selected in accordance with contractual and constructive liabilities as required by PRU 7.6.36 R and appropriate cover for those liabilities as required by PRU 4.2.57 R.
In assessing whether investment risk is reduced, the impact of a transaction on both the assets and liabilities should be considered. In particular, where the amount of liabilities depends upon the fluctuations in an index or other factor, investment risk is reduced where assets whose value fluctuates in the same way match those liabilities. In appropriate circumstances this may include:
- (1)
a derivative or quasi-derivative that is linked to the same index as the liabilities from the index-linked contracts; and
- (2)
a derivative or quasi-derivative whose value depends upon the factors which give rise to general insurance claims, e.g. a weather quasi-derivative.
Cover
A firm must cover an obligation to transfer assets or pay monetary amounts that arises from:
- (1)
a derivative or quasi-derivative; or
- (2)
a contract (other than a contract of insurance) for the purchase, sale or exchange of assets.
An obligation to transfer assets or pay monetary amounts (see PRU 4.3.14 R) must be covered:
- (1)
by assets, a liability or a provision (see PRU 4.3.16 R to PRU 4.3.24 R); or
- (2)
by an offsetting transaction (see PRU 4.3.25 R to PRU 4.3.27 R).
An obligation to pay a monetary amount (whether or not falling in PRU 4.3.16 R) is covered if:
- (1)
the firm holds admissible assets that are sufficient in value so that the firm reasonably believes that following reasonably foreseeable adverse variations (relying solely on cashflows from, or from realising, those assets) it could pay the monetary amount in the right currency when it falls due; or
- (2)
the obligation to pay the monetary amount is offset by a liability. An obligation is offset by a liability where an increase in the amount of that obligation would be offset by a decrease in the amount of that liability; or
- (3)
a provision at least equal to the value of the assets in (1) is implicitly or explicitly set up. A provision is implicitly set up to the extent that the obligation to pay the monetary amount is recognised under PRU 1.3 (Valuation) either by offset against an asset or as a separate liability. A provision is explicitly set up if it is in addition to an implicit provision.
A firm must implicitly or explicitly set up a provision equal to the value of the assets or offsetting transactions held to cover a non-approved derivative or quasi-derivative transaction.
Where a firm partially covers a derivative (or other contract falling within PRU 4.3.14 R (1) and PRU 4.3.14R (2)), the firm may split the derivative into a covered portion and an uncovered portion. The portion of the derivative that is covered (after taking into account the requirement to cover reasonably foreseeable adverse variations in PRU 4.3.17 R (1)) is an approved derivative, provided it also meets the requirements in PRU 4.3.5 R (1) and PRU 4.3.5 R (3); the uncovered portion is not an approved derivative.
Exposure to a transaction includes exposure that arises from a right at the firm's (or its subsidiary undertaking's) option to dispose of assets.
The second purpose of cover is that it prevents excessive gearing in the investment portfolio by the use of options and their equivalent. A firm is required to cover all obligations under an admissible transaction including obligations that would arise only at the option of the firm, e.g. the liability to pay the exercise price under a bought option.
The third purpose of cover is that it protects against the risk that the firm may not be able to deliver assets (including money in any currency) of the right type when the obligation falls due under the transaction. An obligation to deliver assets is covered only if the firm holds those assets or has entered into an offsetting transaction that would deliver those assets when needed. An obligation to pay money is offset only if the firm holds cash in the right currency, its equivalent or assets that could reliably be converted into cash in the right currency.
Cover used for one transaction must not be used for cover in respect of another transaction or any other agreement to acquire, or dispose of, assets or to pay or repay money.
Offsetting transactions
An offsetting transaction means:
- (1)
an approved derivative, approved stock lending transaction or an approved quasi-derivative; or
- (2)
a covered transaction with an approved counterparty for the purchase of assets.
A transaction offsets an obligation to pay a monetary amount only if it provides for that monetary amount to be paid to the firm at or before the earliest date on which the obligation might fall due.
Lending and borrowing assets
Assets that have been lent by the firm are not available for cover, unless:
- (1)
they are non-monetary assets that have been lent under a transaction that fulfils the conditions in PRU 4.3.36 R; and
- (2)
the firm reasonably believes the assets to be obtainable (by return or re-acquisition) in time to meet the obligation for which cover is required.
Assets that have been borrowed by the firm are not available for cover except as allowed by PRU 4.3.30 R.
Borrowed money may be used as cover only where:
- (1)
the money has been advanced or an approved credit institution has committed itself to advance the money; and
- (2)
the borrowing is or would be covered.
PRU 4.3.30 R in effect allows borrowings to be used to bridge the gap between an obligation under a transaction that might fall due at one date and cash or its equivalent that would only become due at a later date. Borrowings may not be used to gear the investment portfolio.
Examples of cover requirements
Examples of cover by assets for the purposes of PRU 4.3.16 R:
- (1)
a bought put option (or a sold call option) on 1000 £1 shares (fully paid) of ABC plc is covered by an existing holding in the fund of 1000 £1 shares (fully paid) of ABC plc;
- (2)
a bought call option (or sold put option) on 1000 ordinary £1 shares (fully paid) of ABC plc is covered by cash (or its equivalent) which is sufficient in amount to meet the purchase price of the shares on exercise of the option;
- (3)
a bought or sold contract for differences on short-dated sterling is covered by cash (or its equivalent), the value of which together at least match the notional principal of the contract. For example, a LIFFE short sterling contract, or a successive series of such contracts, is covered by £500,000; and
- (4)
a sold future on the FT-SE 100 index is covered by holdings of equities, which satisfy the reasonable approximation test for cover in PRU 4.3.16 R (2) in relation to that future, and the values of which together at least match the current mark to market valuation of the future. For example, if the multiplier per full point is £10, and if the eventual obligation under the future is currently 2800, the valuation of the futures position is 2800 x £10 = £28,000.
Examples of cover by offsetting transactions for the purpose of PRU 4.3.25 R would include a bought future which is guaranteed to deliver to the firm at the relevant time sufficient assets to cover liabilities under a sold call option.
Over the counter transactions
For the purpose of PRU 4.3.5 R (3)(b), a transaction is on approved terms only if the counterparty has agreed to enter into a further transaction to close out the first transaction at a price based on current market conditions.
A transaction is capable of valuation only if the firm, throughout the life of the transaction, will be able to value it with reasonable accuracy on a reliable basis reflecting an up-to-date mark-to-market value.
Stock lending
For the purposes of PRU 2 Annex 1R(Admissible assets in insurance), a stock lending transaction is approved if:
- (1)
the assets lent are admissible assets;
- (2)
the counterparty is an authorised person or an approved counterparty; and
- (3)
adequate and sufficiently immediate collateral (PRU 4.3.38 R to PRU 4.3.41 R) is obtained to secure the obligation of the counterparty.
PRU 4.3.36 R refers only to stock lending transactions where the firm is the lender. There are no special rules for a transaction under which the firm borrows securities.
Collateral
For the purposes of PRU 4.3.36 R (3), collateral is adequate only if it:
- (1)
is transferred to the firm or its agent;
- (2)
is, at the time of the transfer, at least equal in value to the value of the securities transferred, or consideration provided, by the firm; and
- (3)
is of adequate quality.
For the purposes of assessing adequate quality in PRU 4.3.38 R (3), reference should be made to the criteria for credit risk loss mitigation set out in PRU 3.2.16 R. The valuation rules in PRU 1.3 apply for the purpose of determining the value of both collateral received and the securities transferred. In addition, collateral that is not an admissible asset does not have a value (see PRU 2 Ann 1).
For the purposes of PRU 4.3.36 R (3), collateral is sufficiently immediate only if:
- (1)
it is transferred before, or at the same time as, the transfer of the securities by the firm; or
- (2)
it will be transferred, at latest, by the close of business on the day of the transfer.
Collateral continues to be adequate only if its value is at all times at least equal to the value of the securities transferred by the firm. This will be satisfied in respect of collateral the validity of which is about to expire or has expired where sufficient collateral will again be transferred at the latest by the close of business on the day of expiry.