PRU 7.1 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.

PRU 7.1 applies to:

1. (1)

   an EEA-deposit insurer; and

2. (2)

   a Swiss general insurer;

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

This section provides guidance on how to interpret PRU 1.4 (Prudential risk management and associated systems and controls) in so far as it relates to the management of insurance risk. Insurance risk refers to fluctuations in the timing, frequency and severity of insured events, relative to the expectations of the firm at the time of underwriting. Insurance risk can also refer to fluctuations in the timing and amount of claim settlements. For general insurance business some specific examples of insurance risk include variations in the amount or frequency of claims or the unexpected occurrence of multiple claims arising from a single cause. For long-term insurance business examples include variations in the mortality and persistency rates of policyholders, or the possibility that guarantees could acquire a value that adversely affects the finances of a firm and its ability to treat its policyholders fairly consistent with the firm's obligations under Principle 6. More generally, insurance risk includes the potential for expense overruns relative to pricing or provisioning assumptions.

Insurance risk concerns the FSA in a prudential context because inadequate systems and controls for its management can create a threat to the regulatory objectives of market confidence and consumer protection. Inadequately managed insurance risk may result in:

1. (1)

   the inability of a firm to meet its contractual insurance liabilities as they fall due; and

2. (2)

   the inability of a firm to treat its policyholders fairly consistent with the firm's obligations under Principle 6 (for example, in relation to bonus payments).

Guidance on the application of this section to a firm that is a member of a group is provided in PRU 8.1 (Group risk systems and controls).

The guidance contained within this section should be read in conjunction with SYSC and PRU 1.4.

Appropriate systems and controls for the management of insurance risk will vary with the scale, nature and complexity of a firm's activities. Therefore, the material in this section is guidance. A firm should assess the appropriateness of any particular item of guidance in the light of the scale, nature and complexity of its activities as well as its obligations, as set out in Principle 3, to organise and control its affairs responsibly and effectively.

High level rules and guidance for prudential systems and controls for insurance risk are set out in PRU 1.4. In particular:

1. (1)

   PRU 1.4.18 R requires a firm to take reasonable steps to establish and maintain a business plan and appropriate risk management systems;

2. (2)

   PRU 1.4.19R (2) requires a firm to document its policy for insurance risk, including its risk appetite and how it identifies, measures, monitors and controls that risk; and

3. (3)

   PRU 1.4.27 R requires a firm to take reasonable steps to establish and maintain adequate internal controls to enable it to assess and monitor the effectiveness and implementation of its business plan and prudential risk management systems.

A firm's insurance risk policy should outline its objectives in carrying out insurance business, its appetite for insurance risk and its policies for identifying, measuring, monitoring and controlling insurance risk. The insurance risk policy should cover any activities that are associated with the creation or management of insurance risk. For example, underwriting, claims management and settlement, assessing technical provisions in the balance sheet, risk mitigation and risk transfer, record keeping and management reporting. Specific matters that should normally be in a firm's insurance risk policy include:

1. (1)

   a statement of the firm's willingness and capacity to accept insurance risk;

2. (2)

   the classes and characteristics of insurance business that the firm is prepared to accept;

3. (3)

   the underwriting criteria that the firm intends to adopt, including how these can influence its rating and pricing decisions;

4. (4)

   its approach to limiting significant aggregations of insurance risk, for example, by setting limits on the amount of business that can be underwritten in one region or with one policyholder;

5. (5)

   where relevant, the firm's approach to pricing long-term insurance contracts, including the determination of the appropriate level of any reviewable premiums;

6. (6)

   the firm's policy for identifying, monitoring and managing risk when it has delegated underwriting authority to another party (additional guidance on the management of outsourcing arrangements is provided in SYSC 3A.9);

7. (7)

   the firm's approach to managing its expense levels, including acquisition costs, recurring costs, and one-off costs, taking account of the margins available in both the prices for products and in the technical provisions in the balance sheet;

8. (8)

   the firm's approach to the exercise of any discretion (e.g. on charges or the level of benefits payable) that is available in its long-term insurance contracts, in the context also of the legal and regulatory constraints existing on the application of this discretion;

9. (9)

   the firm's approach to the inclusion of options within new long-term insurance contracts and to the possible exercise by policyholders of options on existing contracts;

10. (10)

    the firm's approach to managing persistency risk;

11. (11)

    the firm's approach to managing risks arising from timing differences in taxation or from changes in tax laws;

12. (12)

    the firm's approach to the use of reinsurance or the use of some other means of risk transfer;

13. (13)

    how the firm intends to assess the effectiveness of its risk transfer arrangements and manage the residual or transformed risks (for example, how it intends to handle disputes over contract wordings, potential payout delays and counterparty performance risks);

14. (14)

    a summary of the data and information to be collected and reported on underwriting, claims and risk control (including internal accounting records), management reporting requirements and external data for risk assessment purposes;

15. (15)

    the risk measurement and analysis techniques to be used for setting underwriting premiums, technical provisions in the balance sheet, and assessing capital requirements; and

16. (16)

    the firm's approach to stress testing and scenario analysis, as required by PRU 1.2 (Adequacy of financial resources), including the methods adopted, any assumptions made and the use that is to be made of the results.

Further, more detailed, guidance is given in PRU 7.1.11 G to PRU 7.1.37 G on the identification, measurement, monitoring and control (including the use of reinsurance and other forms of risk transfer) of insurance risk. A firm should consider what additional material to that set out above should be included in its insurance risk policy on each of these for its various activities.

A firm should seek to identify the causes of fluctuations in the occurrence, amount and timing of its insurance liabilities. A firm should also seek to identify aggregations of risk that may give rise to large single or multiple claims.

The identification of insurance risk should normally include:

1. (1)

   in connection with the firm's business plan:

   1. (a)

      processes for identifying the types of insurance risks that may be associated with a new product and for comparing the risk types that are present in different classes of business (in order to identify possible aggregations in particular insurance risks); and

   2. (b)

      processes for identifying business environment changes (for example landmark legal rulings) and for collecting internal and external data to test and modify business plans;

2. (2)

   at the point of sale, processes for identifying the underwriting risks associated with a particular policyholder or a group of policyholders (for example, processes for identifying potential claims for mis-selling and for collecting information on the claims histories of policyholders, including whether they have made any potentially false or inaccurate claims, to identify possible adverse selection or moral hazard problems);

3. (3)

   after the point of sale, processes for identifying potential and emerging claims for the purposes of claims management and claims provisioning; this could include:

   1. (a)

      identifying possible judicial rulings;

   2. (b)

      keeping up to date with developments in market practice; and

   3. (c)

      collecting information on industry wide initiatives and settlements.

A firm should also identify potential pricing risks, where the liabilities or costs arising from the sale of a product may not be as expected.

A firm should have in place appropriate systems for collecting the data it needs to measure insurance risk. At a minimum this data should be capable of allowing a firm to evaluate the types of claims experienced, claims frequency and severity, expense levels, persistency levels and, where relevant, potential changes in the value of guarantees and options in long-term insurance contracts.

A firm should ensure that the data it collects and the measurement methodologies that it uses are sufficient to enable it to evaluate, as appropriate:

1. (1)

   its exposure to insurance risk at all relevant levels, for example, by contract, policyholder, product line or insurance class;

2. (2)

   its exposure to insurance risk across different geographical areas and time horizons;

3. (3)

   its total, firm-wide, exposure to insurance risk and any other risks that may arise out of the contracts of insurance that it issues;

4. (4)

   how changes in the volume of business (for example via changes in premium levels or the number of new contracts that are underwritten) may influence its exposure to insurance risk;

5. (5)

   how changes in policy terms may influence its exposure to insurance risk; and

6. (6)

   the effects of specific loss scenarios on the insurance liabilities of the firm.

A firm should hold data in a manner that allows for it to be used in a flexible way. For example, data should be sufficiently detailed and disaggregated so that contract details may be aggregated in different combinations to assess different risks.

A firm should be able to justify its choice of measurement methodologies. This justification should normally be documented.

A firm should periodically review the appropriateness of the measurement methodologies that it uses. This could, for example, include back testing (that is, by comparing actual versus expected results) and updating for changes in market practice.

A firm should ensure that it has access to the necessary skills and resources that it needs to measure insurance risk using its chosen methodology.

When measuring its insurance risks, a firm should consider how emerging experience could be used to update its underwriting process, in particular in relation to contract terms and pricing and also its assessment of the technical provisions in the balance sheet.

A firm should have the capability to measure its exposure to insurance risk on a regular basis. In deciding on the frequency of measurement, a firm should consider:

1. (1)

   the time it takes to acquire and process all necessary data;

2. (2)

   the speed at which exposures could change; and

3. (3)

   that it may need to measure its exposure to certain types of insurance risk on a daily basis (for example, weather catastrophes).

A firm should provide regular and timely information on its insurance risks to the appropriate level of management. This could include providing reports on the following:

1. (1)

   a statement of the firm's profits or losses for each class of business that it underwrites (with an associated analysis of how these have arisen for any long-term insurance contracts), including a variance analysis detailing any deviations from budget or changes in the key performance indicators that are used to assess the success of its business plan for insurance;

2. (2)

   the firm's exposure to insurance risk at all relevant levels (see PRU 7.1.15 G (1)), as well as across different geographical areas and time zones (see PRU 7.1.15 G (2)), also senior management should be kept informed of the firm's total exposure to insurance risk (see PRU 7.1.15 G (3));

3. (3)

   an analysis of any internal or external trends that could influence the firm's exposure to insurance risk in the future (e.g. new weather patterns, socio-demographic changes, expense overruns etc);

4. (4)

   any new or emerging developments in claims experience (e.g. changes in the type of claims, average claim amounts or the number of similar claims);

5. (5)

   the results of any stress testing or scenario analyses;

6. (6)

   the amount and details of new business written and the amount of business that has lapsed or been cancelled;

7. (7)

   identified fraudulent claims;

8. (8)

   a watch list, detailing, for example, material/catastrophic events that could give rise to significant numbers of new claims or very large claims, contested claims, client complaints, legal and other developments;

9. (9)

   the performance of any reinsurance/risk transfer arrangements; and

10. (10)

    progress reports on matters that have previously been referred under escalation procedures (see PRU 7.1.23 G).

A firm should establish and maintain procedures for the escalation of appropriate matters to the relevant level of management. Such matters may include:

1. (1)

   any significant new exposures to insurance risk, including for example any landmark rulings in the courts;

2. (2)

   a significant increase in the size or number of claims;

3. (3)

   any breaches of the limits set out in PRU 7.1.27 G and PRU 7.1.28 G, in particular senior management should be informed where any maximum limits have been breached (see PRU 7.1.29 G); and

4. (4)

   any unauthorised deviations from its insurance risk policy (including those by a broker, appointed representative or other delegated authority).

A firm should regularly monitor the effectiveness of its analysis techniques for setting provisions for claims on general insurance contracts.

A firm should have appropriate procedures in place to allow managers to monitor the application (and hence the effect) of its reinsurance programme. This would include, for a general insurer, procedures for monitoring how its reinsurance programme affects the gross provisions that it makes for outstanding claims (including claims that are incurred but not reported).

A firm should take appropriate action to ensure that it is not exposed to insurance risk in excess of its risk appetite. In so doing, the firm should be both reactive, responding to actual increases in exposure, and proactive, responding to potential future increases. Being proactive should involve close co-ordination between the processes of risk control, risk identification and risk measurement, as potential future exposures need to be identified and understood before effective action can be taken to control them.

A firm should consider setting limits for its exposure to insurance risk, which trigger action to be taken to control exposure. Periodically these limits should be amended in the light of new information (e.g. on the expected number or size of claims). For example, limits could be set for:

1. (1)

   the firm's aggregate exposure to a single source of insurance risk or for events that may be the result of a number of different sources;

2. (2)

   the firm's exposure to specific geographic areas or any other groupings of risks whose outcomes may be positively correlated;

3. (3)

   the number of fraudulent claims;

4. (4)

   the number of very large claims that could arise;

5. (5)

   the number of unauthorised deviations from its insurance risk policy;

6. (6)

   the amount of insurance risk than can be transferred to a particular reinsurer;

7. (7)

   the level of expenses incurred in respect of each relevant business area; and

8. (8)

   the level of persistency by product line or distribution channel.

A firm should also consider setting individual underwriting limits for all employees and agents that have the authority to underwrite insurance risk. This could include both monetary limits and limits on the types of risk that they can underwrite. Where individual underwriting limits are set, the firm should ensure that they are adhered to.

In addition to setting some 'normal' limits for insurance risk, a firm should consider setting some maximum limits, beyond which immediate, emergency action should be taken. These maximum limits could be determined through stress testing and scenario analysis.

A firm should pay close attention to the wording of its policy documentation to ensure that these wordings do not expose it to more, or higher, claims than it is expecting. In so doing, the firm should consider:

1. (1)

   whether it has adequate in-house legal resources;

2. (2)

   the need for periodic independent legal review of policy documentation;

3. (3)

   the use of standardised documentation and referral procedures for variation of terms;

4. (4)

   reviewing the documentation used by other insurance companies;

5. (5)

   revising documentation for new policies in the light of past experience; and

6. (6)

   the operation of law in the jurisdiction of the policyholder.

A firm should ensure that it has appropriate systems and controls for assessing the validity of claims. This could involve consideration of the evidence that will be required from policyholders and how this evidence is to be tested as well as procedures to determine when experts such as loss adjusters, lawyers or accountants should be used.

Particular care should be taken to ensure that a firm has appropriate systems and controls to deal with large claims or large groups of claims that could significantly deplete its financial resources. This should include systems to ensure that senior management (that is, the governing body and relevant senior managers) is involved in the processing of such claims from the outset.

A firm should consider how it intends to use reinsurance or some other form of insurance risk transfer agreement to help to control its exposure to insurance risk. Additional guidance on the use of reinsurance/risk transfer is provided below.

Before entering into or significantly changing a reinsurance agreement, or any other form of insurance risk transfer agreement, a firm should:

1. (1)

   analyse how the proposed reinsurance/risk transfer agreement will affect its exposure to insurance risk, its underwriting strategy and its ability to meet its regulatory obligations;

2. (2)

   ensure there are adequate legal checking procedures in respect of the draft agreement;

3. (3)

   conduct an appropriate due diligence of the reinsurer's financial stability (that is, solvency) and expertise; and

4. (4)

   understand the nature and limits of the agreement (particular attention should be given to the wording of contracts to ensure that all of the required risks are covered, that the level of available cover is appropriate, and that all the terms, conditions and warranties are unambiguous and understood).

In managing its reinsurance agreements, or any other form of insurance risk transfer agreement, a firm should have in place appropriate systems that allow it to maintain its desired level of cover. This could involve systems for:

1. (1)

   monitoring the risks that are covered (that is, the scope of cover) by these agreements and the level of available cover;

2. (2)

   keeping underwriting staff informed of any changes in the scope or level of cover;

3. (3)

   properly co-ordinating all reinsurance/risk transfer activities so that, in aggregate, the desired level and scope of cover is maintained;

4. (4)

   ensuring that the firm does not become overly reliant on any one reinsurer or other risk transfer provider;

5. (5)

   conducting regular stress testing and scenario analysis to assess the resilience of its reinsurance and risk transfer programmes to catastrophic events that may give rise to large and or numerous claims.

In making a claim on a reinsurance contract (that is, its reinsurance recoveries) or some other risk transfer contract a firm should ensure:

1. (1)

   that it is able to identify and recover any money that it is due in a timely manner; and

2. (2)

   that it makes adequate financial provision for the risk that it is unable to recover any money that it expected to be due, as a result of either a dispute with or a default by the reinsurer/risk transfer provider. Additional guidance on credit risk in reinsurance/risk transfer contracts is provided in PRU 3.2 (Credit risk in insurance).

Where the planned level or scope of cover from a reinsurance/risk transfer contract is not obtained, a firm should consider revising its underwriting strategy.

The FSA's high level rules and guidance for record keeping are outlined in SYSC 3.2.20 R (Records). Additional rules and guidance in relation to the prudential context are set out in PRU 1.4.51 G to PRU 1.4.64G. In complying with these rules and guidance, a firm should retain an appropriate record of its insurance risk management activities. This may, for example, include records of:

1. (1)

   each new risk that is underwritten (noting that these records may be held by agents or cedants, rather than directly by the firm provided that the firm has adequate access to those records);

2. (2)

   any material aggregation of exposure to risk from a single source, or of the same kind or to the same potential catastrophe or event;

3. (3)

   each notified claim including the amounts notified and paid, precautionary notices and any re-opened claims;

4. (4)

   policy and contractual documents and any relevant representations made to policyholders;

5. (5)

   other events or circumstances relevant to determining the risks and commitments that arise out of contracts of insurance (including discretionary benefits and charges under any long-term insurance contracts);

6. (6)

   the formal wordings of reinsurance contracts; and

7. (7)

   any other relevant information on the firm's reinsurance or other risk-transfer arrangements, including the extent to which they:

   1. (a)

      have been exhausted by recoveries on paid claims; and

   2. (b)

      will be exhausted by recoveries on reported claims and, to the extent known, on incurred but not reported claims.

A firm should retain its underwriting and claims histories for as long as they may be needed to inform pricing or provisioning decisions.

This section may apply in cases where a firm has its head office in another EEA State but is neither an incoming EEA firm nor an incoming Treaty firm; this could arise in the case of a non-directive mutual or a pure reinsurer.

PRU 7.2 has the aim of reducing the risk that a firm may fail to meet its liabilities to its policyholders as a result of insurance risk, that is, the risk that arises from the inherent uncertainties as to the occurrence, amount and timing of insurance liabilities.

This section requires that the technical provisions that firms establish are adequate to meet their liabilities to policyholders under contracts of insurance. It also requires that firms hold assets of a value sufficient to cover their liabilities, including technical provisions, and that there is suitable matching of assets and liabilities. Technical provisions are the on-balance sheet provisions made by a firm in respect of liabilities arising under or in connection with contracts of insurance. There are different rules and guidance applicable to the calculation of technical provisions for general insurance business and for long-term insurance business.

This section implements requirements of the Insurance Directives for both general insurance business and long-term insurance business with regard to the technical provisions. The relevant articles of the Directives include:

1. (1)

   article 15 of the First Non-Life Directive, as substituted by article 17 of the Third Non-Life Directive; and

2. (2)

   article 20 of the Consolidated Life Directive (this Directive consolidates the provisions of the previous First, Second and Third Life Directives).

This section also sets out detailed rules and guidance on the calculation of the following elements of a firm's capital resources requirement (CRR) (see PRU 2.1):

1. (1)

   the general insurance capital requirement; and

2. (2)

   the long-term insurance capital requirement.

These requirements are dealt with in the part of this section headed "Capital requirements for insurers" (see PRU 7.2.43 G to PRU 7.2.91 R). That part of this section also contains rules about the calculation of the insurance-related capital requirement, which forms part of the enhanced capital requirement for firms carrying on general insurance business. The asset-related capital requirement for firms carrying on general insurance business is set out in PRU 3.3.

For general insurance business, the technical provisions include outstanding claims provisions, unearned premiums provisions, unexpired risk provisions and equalisation provisions. These provisions take into account the expected ultimate cost of claims, including those not yet incurred, related expenses and include an allowance for smoothing claims (the equalisation provision).

Discounting (that is discounting for the time value of money) general insurance business technical provisions may be carried out only in limited circumstances and on a prudent basis (see PRU 2.2.80R and PRU 2.2.81R and paragraph 48 of the insurance accounts rules). The fact that the expected liabilities are generally not discounted helps to protect against risk from inherent uncertainty in the timing, but not necessarily the amount, of claims.

For some categories of general insurance business, equalisation provisions are required. These ensure that a firm retains additional assets to provide some extra protection against uncertainty as to the amount of claims. Equalisation provisions are particularly suitable for volatile business, where claims in any future year may be subject to significant adverse deviation from recent or average expected claims experience, or where trends in claims experience may be subject to change. Such volatile claims experience arises in a number of types of business, for example, property, marine and aviation, nuclear, certain non-proportional reinsurance treaty business, and credit insurance. The equalisation provisions help to equalise fluctuations in loss ratios in future years (see PRU 7.5 (Equalisation provisions)).

Rules and guidance for calculating mathematical reserves are set out in PRU 7.3. Firms are advised by the actuarial function (see SUP 4) on the methods and assumptions to be used in calculating the mathematical reserves. The standards and guidance issued by the Faculty and Institute of Actuaries to assist actuaries appointed to the actuarial function are important sources of evidence as to generally accepted actuarial practice, as referred to in PRU 7.2.16 R (1).

For long-term insurance business, the technical provisions include the mathematical reserves. These are actuarial estimates of a firm's liabilities in respect of future benefits due to policyholders, including bonuses already declared. The mathematical reserves may be reduced by the actuarial value of that component of future premiums attributable to meeting future liabilities (see PRU 7.3 (Mathematical reserves)).

For long-term insurance business, the mathematical reserves are typically valued on a discounted basis but include valuation margins intended to provide protection against adverse deviations in experience (see PRU 7.3).

PRU 7.6 (Internal-contagion risk) sets out the rules and guidance on identifying and holding in a separate fund long-term insurance assets.

When valuing assets for the purposes of PRU 7.2.20 R and PRU 7.2.21 R, a firm should bear in mind:

1. (1)

   that the technical provisions should be covered by admissible assets (see PRU 2 Annex 1 RR); and

2. (2)

   the market and counterparty limits set out in PRU 3.2 (Credit risk in insurance). PRU 3.2 requires that a firm restrict to prudent levels its exposure to reinsurer and other counterparties, and, in particular, that for the purpose of its balance sheet, a firm must not take into account any exposure which exceeds the large exposure limits.

Rules and guidance on the valuation of assets are set out in PRU 1.3 (Valuation), including the treatment of shares in, and debts due from, related undertakings in PRU 1.3.31R to PRU 1.3.42 G. PRU 4.2 (Market risk in insurance) addresses market risk and sets out the matching requirements for linked assets and liabilities. PRU 4.2 also sets out rules and guidance on the matching by currency of assets and liabilities, to reduce a firm's exposure to currency market risk.

Certain debts and claims are excluded from PRU 7.2.20 R, PRU 7.2.21 R, PRU 7.2.27 R and PRU 7.2.28 R to avoid double-counting. The rules and guidance in PRU 7.3 (Mathematical reserves) set out how a firm may offset debts and claims against liabilities in calculating the mathematical reserves required for long-term insurance business. Tax recoveries and claims against compensation funds in PRU 7.2.25 R (2) are set out in the list of admissible assets (see PRU 2 Annex 1R).1

PRU 7.2.27 R and PRU 7.2.28 R support the funding of policyholder benefits by requiring firms to maintain admissible assets in with-profits funds to cover the technical provisions relating to all the business in that fund and, in the case of a realistic basis life firm, realistic assets to cover the realistic liabilities of the with-profits insurance contracts written in the fund.

PRU 7.6 (Internal contagion risk) sets out the rules and guidance on localisation for firms other than UK firms.

A firm should take account of the amount, currency and timing of its expected cash outflows in determining whether the assets it holds to cover its technical provisions meet the requirements of PRU 7.2.34 R (2).

For the purpose of PRU 7.2.34 R (2), the relevant cash inflows are those which the firm reasonably expects to receive from the admissible assets which it holds to cover its technical provisions. A firm may receive cash inflows as a result of:

1. (1)

   selling assets or closing out transactions;

2. (2)

   holding assets that generate dividends, interest or other income; and

3. (3)

   receiving future premiums for existing business.

Anticipated cash inflows from future new business should not be included, for example where the customer has not yet contracted to pay the premium, and where the associated liabilities and potential cash outflows should also not be included.

A firm should compare cash inflows and outflows based on current expectations of amounts and timings. Current market expectations of future asset values, interest rates and currency exchange rates should be used. Where inflows are received in a currency different from that in which outflows are to be paid, account should be taken of the cost of converting the currency received.

In considering the value and suitability of assets required to ensure that the firm's liabilities are met as they become due, a firm should take account of the risk of default on inflows from those assets, and other risks that may mean that future inflows are reduced relative to outflows.

PRU 7.2.20 R lays down a general requirement for a firm that carries on long-term insurance business to hold admissible assets that are of a value sufficient to cover its mathematical reserves (calculated in accordance with the rules in PRU 7.3). The PRU 7.2.34 R (2) requirement to match liabilities with assets that allow cash outflows to be met with suitable inflows as the outflows become due may mean that a firm has to hold assets of a value greater than would otherwise be required by the general rule in PRU 7.2.20 R.

For the purposes of PRU 7.2.41 R, the adequacy of premiums may be assessed in the context of a firm's total portfolio of business and its other resources. It thus does not prevent a firm writing loss leaders nor writing contracts which might incur large losses, but only if the firm can meet the losses that might reasonably arise, including those that would arise from an event specifically insured against.

1. (1)

   PRU 2.1.9R requires a firm to maintain capital resources equal to or in excess of its capital resources requirement (CRR). PRU 2.1 sets out the overall framework of the CRR; in particular, PRU 2.1.14 R requires that for a firm carrying on general insurance business the CRR is equal to the minimum capital requirement (MCR). PRU 2.1.15 R requires that for realistic basis life firms the CRR is the higher of the MCR and the ECR. PRU 2.1.20 R requires that for regulatory basis only life firms the CRR is equal to the MCR.

2. (2)

   For non-life firms the MCR represents the minimum capital requirement (or margin of solvency) prescribed by the Insurance Directives. PRU 2.1.21 R provides that, for a firm carrying on general insurance business, the MCR in respect of that business is the higher of the base capital resources requirement for general insurance business applicable to that firm and the general insurance capital requirement. PRU 2.1.22 R provides that, for a firm carrying on long-term insurance business, the MCR in respect of that business is the higher of the base capital resources requirement for long-term insurance business applicable to that firm and the sum of the long-term insurance capital requirement and the resilience capital requirement. As specified in PRU 2.1.10 R, a firm carrying on both general insurance business and long-term insurance business must apply PRU 2.1.9R (referred to in paragraph (1) above) separately to its general insurance business and its long-term insurance business.

3. (3)

   The calculation of the general insurance capital requirement is set out in PRU 7.2.44 G to PRU 7.2.72 R below. PRU 7.2.73 G to PRU 7.2.79 R set out the calculation of the insurance-related capital requirement for non-life firms. The calculation of the long-term insurance capital requirement is set out in PRU 7.2.80 G to PRU 7.2.91 R below.

In relation to the MCR (see PRU 7.2.43 G), PRU 2.1.30 R requires a firm to calculate its general insurance capital requirement (GICR) as the highest of the premiums amount, the claims amount, and the brought forward amount. The elements for this computation are set out in PRU 7.2 as follows:

1. (1)

   the premiums amount in PRU 7.2.45 R;

2. (2)

   the claims amount in PRU 7.2.47 R; and

3. (3)

   the brought forward amount in PRU 7.2.51 R.

Rules and guidance as to how the gross adjusted premiums amount is to be calculated are set out in PRU 7.2.56 R to PRU 7.2.59 G.

Rules and guidance as to how the gross adjusted claims amount is to be calculated are set out in PRU 7.2.60 R to PRU 7.2.65 G.

The brought forward amount is the same as the GICR for the prior financial year, except where claims outstanding have fallen during that financial year. If they have fallen, the brought forward amount is itself reduced by the same percentage fall.

If the GICR for the prior financial year is less than the premiums amount or the claims amount, then a brought forward amount is not required to be calculated.

Rules and guidance as to how the net and gross claims are to be calculated are set out in PRU 7.2.66 R to PRU 7.2.71 R.

A firm may use statistical methods in order to allocate premiums in respect of the classes 11, 12 and 13 for the purposes of PRU 7.2.56 R.

General insurance business classes 11, 12 and 13 are, respectively, the marine liability, aviation liability and general liability insurance classes.

Where the firm did not carry on insurance business in the financial year in question, the gross adjusted premiums amount, and therefore the premiums amount, is nil.

A firm may use statistical methods in order to allocate claims in respect of classes 11, 12 and 13 for the purposes of PRU 7.2.60 R.

The classification of the risks referred to in PRU 7.2.63 R (2) is as follows: credit - as included in general insurance business class 14; storm - as included in general insurance business class 8; hail - as included in general insurance business class 9; and frost - as included in general insurance business class 9.

Where the firm did not carry on insurance business in the reference period, the gross adjusted claims amount, and therefore the claims amount, is nil.

To ensure that all rights and obligations under a contract of insurance are transferred, a number of alternative mechanisms could be used. These are: an insurance business transfer under Part VII of the Act; under earlier United Kingdom insurance legislation; under equivalent foreign legislation; or by novation of contracts. The term "relevant authority" in paragraph (2) of PRU 7.2.66 R may refer to whatever body has responsibility in a country, whether within or outside the EEA, for the approval of transfers of portfolios of contracts of insurance; the body may be a supervisory authority for financial services as such or it may be a judicial authority which has the necessary responsibility.

PRU 7.2.66 R (2)(b) requires a firm, for the purpose of calculating its GICR, to account for contracts of insurance transferred by it to another body as if it had never written those contracts. All amounts of premiums and claims arising in respect of those contracts are excluded, including amounts that arose in the financial year in question or previous financial years.

Conversely, PRU 7.2.66 R (2)(c) requires a firm, for the purpose of calculating its GICR, to account for contracts of insurance transferred to it by another body as if it had been responsible for those contracts from inception and not merely from the date of transfer. All amounts of premiums and claims that arose from those contracts are included even where they arose prior to the date of transfer and were, in fact, receivable by or payable to the other body.

For both transfers to and from the firm, the consideration receivable or payable in respect of the transfer is excluded from premiums and claims in order to avoid double counting.

PRU 2.3.11 R requires firms carrying on general insurance business, other than a non-directive insurer, to calculate their ECR as the sum of the asset-related capital requirement and the insurance-related capital requirement less the firm's equalisation provisions. 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 firms carrying on general insurance business, the FSA will use the ECR as a benchmark for individual capital guidance for a firm carrying on general insurance business. Details of the calculation of the asset-related capital requirement are set out in PRU 3.3. 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.

The insurance-related capital requirement is a measure of the capital that a firm should hold against the risk of:

1. (1)

   an adverse movement in the value of a firm's liabilities, to recognise that there may be substantial volatility in claims and other technical provisions made by the firm. Such variations may be due to inflationary increases, interest rate changes, movements in the underlying provisions themselves, changes in expense costs, inadequate rate pricing or premium collections (or both) from intermediaries differing from projected assumptions; and

2. (2)

   the premiums a firm charges in respect of particular business not being adequate to fund future liabilities arising from that business.

The insurance-related capital requirement is calculated by applying capital charge factors, expressed as a percentage, to the value of the net written premiums and the technical provisions in respect of different classes of business. Firms should refer to PRU 1.3.5 R which sets out how a firm must recognise and value assets and liabilities.

PRU 2.1.9 R requires a firm to which PRU 2 applies to maintain capital resources equal to or in excess of its capital resources requirement. PRU 2.1.15 R defines the capital resources requirement for a firm to which that rule applies (a realistic basis life firm) as the higher of the MCR and the ECR. For other firms carrying on long-term insurance business (regulatory basis only life firms), the capital resources requirement is equal to the MCR. The MCR is defined as the higher of the base capital resources requirement and the sum of the long-term insurance capital requirement (LTICR) and the resilience capital requirement (see PRU 2.1.22 R). PRU 2.1.32 R defines the LTICR as the sum of the insurance death, health, expense, and market riskcapital components (see PRU 7.2.81 R to PRU 7.2.91 R). Rules and guidance about the resilience capital requirement are set out in PRU 4.2.9 G to PRU 4.2.26 R.

The insurance death risk capital component only relates to the risk of death. There is a separate risk component for insured health risks (class IV). Tontines (class V) and capital redemption operations (class VI) also have separate risk components. There is no specified risk margin for other insured risks.

The insurance health risk capital component only arises for permanent health insurance (long-term insurance business class IV) and accident and sickness insurance (general insurance business classes 1 and 2).

This section follows on from the overall requirement on firms to establish adequate technical provisions (see PRU 7.2.16 R). The mathematical reserves form the main component of technical provisions for long-term insurance business. PRU 7.3 sets out rules and guidance as to the methods and assumptions to be used in calculating the mathematical reserves. The rules and guidance set out the minimum basis for mathematical reserves. Methods and assumptions that produce reserves that are demonstrably equal to or greater than the minimum basis may also be used, though they must meet the basic requirements for methods and assumptions set out in PRU 7.3.7 R to PRU 7.3.27 G.

This section applies to all firms carrying on long-term insurance business and implements some of the requirements contained in article 20 of the Consolidated Life Directive. The implementation is designed to ensure that a firm's mathematical reserves in respect of long-term insurance contracts meet the minimum requirements set by the Consolidated Life Directive. A firm may use a prospective or a retrospective method to value its mathematical reserves(see PRU 7.3.7 R).

The required procedures are summarised in the flowchart inPRU 7 Annex 1G.

Firms to which PRU 2.1.15R applies are required to calculate a with-profits insurance capital component (see PRU 2.1.34 R). In order to calculate its with-profits insurance capital component, such a firm is required to carry out additional calculations of its liabilities on a realistic basis (see PRU 7.4), which it is required to report to the FSA (see Forms 18,19). A firm that reports its liabilities on a realistic basis is referred to in PRU as a realistic basis life firm. Such firms are subject to different rules relating to the calculation of mathematical reserves (see PRU 7.3.46 R and PRU 7.3.76 R) compared with those that apply to firms that report on a regulatory basis only (regulatory basis only life firms).

A number of the rules in this section require a firm to take into account its regulatory duty to treat customers fairly. In this section, references to such a duty are to a firm's duty to pay due regard to the interests of its customers and to treat them fairly (see Principle 6 in PRIN). This duty is owed to both policyholders and potential policyholders.

A prospective valuation sets the mathematical reserves at the present value of future net cash flows. A retrospective method typically sets the mathematical reserves at the level of premiums received (and accumulated with investment return), less claims and expenses paid. A prospective valuation is preferred because it takes account of circumstances that might have arisen since the premium rate was set and of changes in the perception of future experience. Circumstances in which a retrospective valuation might be appropriate include:

1. (1)

   where the assumptions initially made in determining the premium rate were sufficiently prudent at inception and have not been overtaken by subsequent events; and

2. (2)

   where the liability depends on the emerging experience.

PRU 7.3.10 R (2) prohibits only arbitrary changes in methods and assumptions, that is, changes made without adequate reasons. Any such changes would hinder comparisons over time as to the amount of the mathematical reserves and so obscure trends in solvency and the emergence of surplus.

The relevant factors referred to in PRU 7.3.10 R (4) may include, but are not limited to, factors such as future investment returns, expenses, mortality, morbidity, options, persistency and reinsurance (see also PRU 7.3.13 R to PRU 7.3.19 G).

The margins for adverse deviation are a prudential margin in respect of the risks that arise under a long-term insurance contract.

PRU 7.3.13 R sets the normal standard of prudence required for margins. PRU 7.3.16 G suggests benchmarks against which a firm should compare the margins it has set in accordance with PRU 7.3.10 R (4) and PRU 7.3.13 R. PRU 7.3.17 G gives guidance where a market risk premium is not readily obtainable.

When setting the margins for adverse deviation required by PRU 7.3.10 R (4) in relation to a particular contract, a firm should consider, where appropriate:

1. (1)

   the margin for adverse deviation included in the premium for similar long-term insurance contracts, if any, newly issued by the firm; and

2. (2)

   where a sufficiently developed and diversified market for transferring a risk exists, the risk premium that would be required by an unconnected party to assume the risk in respect of the contract.

The margin for adverse deviation of a risk should generally be greater than or equal to the relevant market price for that risk.

Where a risk premium is not readily available, or cannot be determined, an external proxy for the risk should be used, such as adjusted industry mortality tables. Where there is a considerable range of possible outcomes, the FSA expects firms to use stochastic techniques to evaluate these risks. In time, for example, longevity risk, where this constitutes a significant risk for the firm, may fall into this category.

The margins for adverse deviation should be recognised as profit only as the firm itself is released from risk over the duration of the contract.

Further detailed rules and guidance on margins for adverse deviation are included in PRU 7.3.32 G to PRU 7.3.91 G. In particular, the cross-references for the different assumptions used in calculating the mathematical reserves are as follows:

1. (1)

   expenses (PRU 7.3.50 R to PRU 7.3.58 G);

2. (2)

   mortality and morbidity (PRU 7.3.59 R to PRU 7.3.61 G);

3. (3)

   options (PRU 7.3.62 R to PRU 7.3.72 G);

4. (4)

   persistency (PRU 7.3.73 G to PRU 7.3.77 G); and

5. (5)

   reinsurance (PRU 7.3.78 G to PRU 7.3.91 G).

The rules and guidance on margins for adverse deviation in respect of future investment returns, which are also required in the calculation of mathematical reserves, are set out in PRU 4.2.28 R to PRU 4.2.48 G.

PRU 1.4.53 R requires firms to maintain accounting and other records for a minimum of three years, or longer as appropriate. For the purposes of PRU 7.3.20 R, a period of longer than three years will be appropriate for a firm's long-term insurance business. In determining an appropriate period, a firm should have regard to:

1. (1)

   the detailed rules and guidance on record keeping in PRU 1.4.51 G - PRU 1.4.64 G;

2. (2)

   the nature and term of the firm's long-term insurance business; and

3. (3)

   any additional provisions or statutory requirements applicable to the firm or its records.

PRU 7.3.22 R to PRU 7.3.91 G set out rules and guidance for the separate prospective valuation of each contract. These may be applied instead to groups of contracts where the conditions set out in PRU 7.3.22 R (2) are satisfied.

A separate prospective valuation for each contract may identify contracts for which the value of future cash inflows exceeds that of outflows, that is, the contracts have an asset value, rather than liability value. However, the surrender value of a contract is always greater than or equal to zero and the Consolidated Life Directive requires that no contract should be valued at less than its guaranteed surrender value. As a result, no contract should be treated as an asset.

The valuation of each contract, or group of similar contracts, should allow for the possibility, where it exists, that contracts may be surrendered (wholly or in part), lapsed or made paid-up at any time. The valuation assumptions include margins for adverse deviation (see PRU 7.3.13 R). PRU 7.3.26 R requires mathematical reserves to be established such that, if future experience is in line with the valuation assumptions, there would be no future valuation strain.

All cash flows are to be valued using prudent assumptions in accordance with generally accepted actuarial practice. Cash flows may be omitted from the valuation calculations provided the reserves obtained as a result of leaving those cash flows out of the calculation are not less than would have resulted had all cash flows been included (see PRU 7.3.22 R (2)). Provision for future expenses in respect of with-profits insurance contracts (excluding accumulating with-profits policies) may be made implicitly, using the net premium method of valuation (see PRU 7.3.43 R below). For the purposes of PRU 7.3.28 R (2), any charges included in expenses should be determined in accordance with the firm's regulatory duty to treat its customers fairly.

PRU 7.3.29 R (4) requires regulatory basis only life firms to make allowance for any future annual bonus that a firm would expect to grant, assuming future experience is in line with the assumptions used in the calculation of the mathematical reserves. Final bonuses do not have to be taken into consideration in these calculations (see PRU 7.3.9 R). For realistic basis life firms, except for accumulating with-profits policies, the mathematical reserves may be calculated as the amount required to cover guaranteed benefits as for such firms full allowance for discretionary benefits is made in the calculation of the realistic value of liabilities (see PRU 7.4.105 R (5)). The calculations required for accumulating with-profits policies are set out in PRU 7.3.71 R (1).

More detailed rules and guidance about the valuation of cash flows are set out in PRU 7.3.33 R to PRU 7.3.91 G.

The rules in PRU 4.2.28 R to PRU 4.2.47 R set out the approach firms must take in setting margins for adverse deviation in the interest rates assumed in calculating the mathematical reserves. This includes a margin to allow for adverse deviation in market risk and, where relevant, credit risk. The requirements set out in PRU 4.2.28 R to PRU 4.2.47 R protect against the market risk that the return actually achieved on assets may fall below the market yields on assets at the actuarial valuation date.

PRU 7.3.46 R and PRU 7.3.47 G apply to the valuation of with-profits insurance liabilities for a realistic basis life firm. PRU 7.3.38 R to PRU 7.3.45 G apply to a regulatory basis only life firm.

For non-profit insurance contracts no specific method of valuation for future premiums is required by PRU. However, the method of valuation used should be sufficiently prudent taking into account, in particular, the risk of voluntary discontinuance by the policyholder.

The valuation method for future premiums in PRU 7.3.38 R retains the difference, if any, between the gross premium and the net premium as an implicit margin available to finance future bonuses, expenses and other costs. It thus helps to protect against the risk that adequate resources may not be available in the future to meet those costs.

PRU 7.3.41 R permits three alternative methods. However, the third method is only possible where a meaningful comparison can be made between the terms of the contract (as changed) and the terms upon which the firm was effecting its new contracts of insurance at the time the contract was changed.

PRU 7.3.43 R allows a firm to spread acquisition costs over the lifetime of a contract of insurance, but only if it is reasonable to expect those costs to be recoverable from future premium income from that contract. Further prudence is provided by the limitation of recoverable acquisition expenses to 3.5% of the relevant capital sum. This adjustment for acquisition costs is sometimes termed a Zillmer adjustment.

In determining the extent, if any, to which it is reasonable to expect acquisition costs to be recoverable from future premium income, the firm should make prudent assumptions as to levels of voluntary discontinuance by policyholders.

The gross premium is the full amount of premium payable by the policyholder to the firm. The gross premium method contrasts with the net premium method which is required from regulatory basis only life firms (see PRU 7.3.37 R to PRU 7.3.45 G).

PRU 7.3.48 R prohibits a firm from taking credit for recurring single premiums under accumulating with-profits policies. As there is no contractual commitment to pay any future premiums the amount and timing of which are uncertain, the recognition of any potential margins would not be prudent. Where the payment of a future premium would give rise to a liability in excess of the premium a provision should be established.

For with-profits insurance contracts where the net premium valuation method applies, an implicit provision arises because the future premiums valued are limited to the net premium adjusted as permitted by PRU 7.3.43 R. This excludes the allowance within the gross premium for expenses (other than recoverable acquisition expenses). It also excludes other margins within the actual premium that are a prudential margin in respect of the risks that arise under the contract or that are needed to provide for future discretionary benefits. To the extent that these other margins are not needed for the purpose for which they were originally established, they may also constitute an implicit provision for expenses.

An implicit provision may also arise for other types of long-term insurance contract where, for example, no value is attributed to future premiums, but the firm is entitled to make deductions from future regular premiums before allocating them to secure policyholder benefits.

A firm should only reduce the provision for future expenses to take account of expected taxation recoveries related to those expenses where recovery is reasonably certain, and after taking into account the assumption that the firm ceases to transact new business 12 months after the actuarial valuation date. An appropriate adjustment for discounting should be made where receipt of the taxation recoveries is not expected until significantly after the expenses are incurred.

The firm's actual expenses in the 12 months prior to the actuarial valuation date may serve as a guide to the assumptions for future expenses, taking into consideration the mix of acquisition and renewal expenses. The expense assumptions should not be reduced to account for expected future improvements in efficiency until such efficiency improvements result in a reduced level of actual expenditure. However, the assumptions should take account of all factors which might increase costs including earnings and price inflation.

The provision for future expenses, whether implicit or explicit, should include a prudent margin for adverse deviation in the level and timing of expenses (see PRU 7.3.13 R to PRU 7.3.19 G). The margin should cover the risk of underestimating expenses whether due to, for example, initial under-calculation or subsequent increases in the amount of expenses. In setting the amount of the margin, the firm should take into account the extent to which:

1. (1)

   an appropriately validated method based on reliable data is used to allocate expenses by product type, by distribution channel and as between acquisition and non-acquisition expenses;

2. (2)

   the volume of existing and new business and its distribution by product type or distribution channel is stable or predictable;

3. (3)

   costs vary in the short, medium or long term dependent upon the volume of existing or new business and its distribution by product type or distribution channel; and

4. (4)

   cost control is well-managed.

In setting the margin, the firm should also take into account:

1. (1)

   the length of the period over which it is necessary to project costs;

2. (2)

   the extent to which it is reasonable to expect inflation to be stable or predictable over that period; and

3. (3)

   whether, if inflation is higher than expected, it is reasonable to expect that the excess would be offset by increases in investment returns.

Where a firm has entered into an agreement with any other person for the sharing or reimbursement of costs, in setting the margin it should take into account the potential impact of that agreement and of its discontinuance.

The rates of mortality or morbidity should contain prudent margins for adverse deviation (see PRU 7.3.13 R to PRU 7.3.19 G). In setting those rates, a firm should take account of:

1. (1)

   the systems and controls applied in underwriting long-term insurance contracts and whether they provide adequate protection against anti-selection (that is, selection against the firm) including:

   1. (a)

      adequately defining and identifying non-standard risks; and

   2. (b)

      where such risks are underwritten, allocating to them an appropriate weighting;

2. (2)

   the nature of the contractual exposure to mortality or morbidity risk including:

   1. (a)

      whether lower mortality increases or decreases the firm's liability;

   2. (b)

      the period of cover and whether risk charges can be varied during that period and, if so, how quickly; and

   3. (c)

      whether the options in the contract give rise to a significant risk of anti-selection (for example, opportunities for voluntary discontinuance, guaranteed renewal at the option of the policyholder and rights for conversion of benefits);

3. (3)

   the credibility of the firm's actual experience as a basis for projecting future experience including:

   1. (a)

      whether there is sufficient data (especially for medical or financial risks and for new types of benefit or new methods of distribution); and

   2. (b)

      whether the data is reliable and has been appropriately validated;

4. (4)

   the availability and reliability of:

   1. (a)

      any published tables of mortality or morbidity for the country or territory of residence of the person whose life or health is insured; and

   2. (b)

      any other information as to the industry-wide insurance experience for that country or territory;

5. (5)

   anticipated or possible future trends in experience including, but only where they increase the liability:

   1. (a)

      anticipated improvements in mortality;

   2. (b)

      changes arising from improved detection of morbidity (including critical illnesses);

   3. (c)

      diseases the impact of which may not yet be reflected fully in current experience; and

   4. (d)

      changes in market segmentation (such as impaired life annuities) which, in the light of developing experience, may require different assumptions for different parts of the policy class.

An additional provision for diseases covered by PRU 7.3.60 G (5)(c) may be needed, in particular for unit-linked policies. In determining whether such a provision is needed a firm may take into consideration any ability to increase product charges commensurately (provided that such increase does not infringe on its regulatory duty to treat its customers fairly), but a provision would still be required for the period until such an increase could be brought into effect.

An option exists where a policyholder is given a choice between alternative forms of benefit, for example, a choice between receiving a cash benefit upon maturity or an annuity at a guaranteed rate. In some cases, the contract may designate one or other of these alternatives as the principal benefit and any other as an option. This designation, in itself, is not one of substance in the context of reserving since it does not affect the policyholder's choices. Other forms of option include:

1. (1)

   the right to convert to a different contract on guaranteed terms;

2. (2)

   the right to increase cover on guaranteed terms;

3. (3)

   the right to a specified amount on surrender; and

4. (4)

   the right to a paid up value.

The firm should provide for the benefit which the firm anticipates the policyholder is most likely to choose. Except for the "option" of voluntary discontinuance in the case of regulatory basis only life firms (see PRU 7.3.74 R), past experience may be used as a guide, but only if this is likely to give a reasonable estimate of future experience. For example, past experience of the take-up of a cash payment option instead of an annuity would not be a reliable guide, if, in the past, market rates exceeded those guaranteed in the annuity but no longer do so. Similarly, past experience on the take-up of options may not be relevant in the light of the assumptions made in respect of future interest rates and mortality rates in the valuation of the benefits.

Many options are long-term and need careful consideration. Improving longevity, for example, can increase the value of guaranteed annuity options vesting further in the future. Firms also need to have regard to the fact that policyholder behaviour can change in the future as policyholders become more aware of the value of their options. The impact on policyholder behaviour of possible changes in taxation should also be considered.

In accordance with PRU 7.3.7 R and PRU 7.3.13 R, take-up rates for guaranteed annuity options should be assessed on a prudent basis with assumptions that include margins for adverse deviation (see PRU 7.3.13 R to PRU 7.3.19 G) that take account of current experience and the potential for future change. The firm should reserve for option take-up at least at a prudent margin over current experience for options shortly to vest. For longer term options where the option becomes increasingly valuable in the future due to projected mortality improvements, increased take-up rates should be assumed. In view of the growing uncertainty over take-up rates for projections further in the future, for guaranteed annuity option dates 20 years or more ahead at least a 95% take-up rate assumption should be made.

Where there is considerable variation in the cost of the option depending on conditions at the time the option is exercised, and where that variation constitutes a material risk for the firm, it will generally be appropriate to use stochastic modelling. In this case prices from the asset model used in the stochastic approach should be benchmarked to relevant market asset prices before determining the value of the option. Where stochastic modelling is not undertaken, market option prices should be used to determine suitable assumptions for the valuation of the option. If no market exists for a particular option, a firm should take the value of the nearest equivalent benefit or right for which a market exists and document the way in which it has adjusted that valuation to reflect the original option.

Where the option offers a choice between two non-discretionary financial benefits (such as between a guaranteed cash sum or a guaranteed annuity value, or between a unit value and a maturity guarantee) and where there is a wide range of possible outcomes, the firm should normally model such liabilities stochastically. In carrying out such modelling firms should take into account the likely choices to be made by policyholders in each scenario. Firms should make and retain a record of the development and application of the model.

The value of a contract with an option is greater than the value of a similar contract without the option, that is, the option has value whether it is expected to be exercised or not. Although in theory a firm can rebalance its investments to match the expected cost of the option to the firm (including the time value of the option), this takes time to achieve and the market may move more quickly than the firm is able to respond. Also, there are likely to be transaction costs. Firms should take these aspects into consideration in setting up mathematical reserves.

In PRU 7.3.71 R (1)(a)firms must take into consideration, for example, a market value adjustment where such an adjustment has been described in representations made to policyholders by the firm. However, any discretionary adjustment, such as a market value adjustment, cannot be included in the amount calculated in PRU 7.3.71 R (1)(b).

PRU 7.3.76 R and PRU 7.3.77 G apply to the valuation of the with-profits insurance liabilities of realistic basis life firms. PRU 7.3.74 R and PRU 7.3.75 G apply to the valuation of all other liabilities.

The rate of voluntary discontinuance (that is, lapse, surrender or paying up) is often difficult to predict and may be volatile especially in the short term during stressful economic conditions. Depending upon the circumstances and contract terms, voluntary discontinuance may increase or decrease the firm's liability. In effect, PRU 7.3.74 R requires a firm to assume that there will be no voluntary discontinuance if assuming voluntary discontinuance would reduce the liability. This protects against the risk that arises from volatility in the rate of voluntary discontinuance. In addition, there is the risk of assets not being realisable when needed due to the rates of discontinuance exceeding expected levels.

The prudential margin in respect of assumptions of voluntary discontinuance should be validated both in relation to recent experience and to variations in future experience that might arise as a result of reasonably foreseeable changes in conditions. In particular, where estimates of experience are being made well into the future, the assumptions should contain margins that take into account the increased risk of adverse experience arising from changed circumstances. Firms should also consider the possibility of anti-selection by policyholders and of variations in persistency experience for different classes and cohorts of business.

The prospective valuation of future cash flows to determine the amount of the mathematical reserves includes amounts to be received or paid under contracts of reinsurance in respect of long-term insurance business (see PRU 7.3.28 R (4)). This applies even where those cash flows cannot be identified as related to particular long-term insurance contracts (see PRU 7.3.22 R (3)).

In valuing reinsurance cash flows, a firm should establish prudent margins for adverse deviation (see PRU 7.3.13 R to PRU 7.3.19 G) including margins in respect of:

1. (1)

   any uncertainty as to the amount or timing of amounts to be paid or received; and

2. (2)

   the risk of credit default by the reinsurer.

In assessing the risk of credit default, the firm should take into account the rules and guidance in PRU 3.2 (Credit risk in insurance).

It will not necessarily be appropriate to use the same assumptions in PRU 7.3.79 R as for the underlying contracts. For example, if only a subgroup of the original contracts is reinsured, it may be appropriate to use different mortality rates.

Only reinsurance cash inflows that are triggered unambiguously by the insurance risks of the firm that are reinsured may be valued. Reinsurance cash inflows that depend on other contingencies where the outcome does not form part of the valuation basis should not be given credit.

Firms should assess the extent of margins in the valuation of the existing contracts of insurance where these provide implicit provision for the reinsurance cash outflows in PRU 7.3.79 R. Where the reinsurance asset exceeds the estimated value of the future surplus under reinsured contracts firms should assess their credit risk exposure to the reinsurer.

For the purposes of PRU 7.3.85 R, a contingent liability means a liability that would only arise upon the happening of a particular contingency, even where that contingency is not expected to occur. For example, if the firm has a reinsurance arrangement in force that in the event the firm were wound up would give rise to repayments other than out of surplus emerging, the reinsurance cash outflows should be valued as a liability.

PRU 7.3.85 R allows a firm not to value reinsurance cash outflows provided the contingencies in which the reinsurance would require repayment other than out of future surpluses are limited to termination clauses concerning fraud, misrepresentation, non-payment of reinsurance premiums by the firm or a failure by the firm to obtain the agreement of the reinsurer to a transfer of business by the firm.

Where the reinsurance cash outflow is payable by a fund or sub-fund that generates such profits, charges or transfers, the firm need make no provision for such payments provided that repayment to the reinsurer is linked unambiguously (as defined in PRU 7.3.85 R) to the emergence of future surplus. Where the profits, charges or transfers arising under a block of business are payable by a fund or sub-fund to another part of the firm then only where the firm has committed to remit such profits, charges or transfers directly to the reinsurer would it be acceptable for no provision for payments to the reinsurer to be made.

In PRU 7.3.78 G to PRU 7.3.89 G references to reinsurance cash outflow include any provision for the reduction in policy liabilities recognised as covered under a contract of reinsurance or for the reduction of any debt to the firm previously created under a contract of reinsurance. In PRU 7.3.90 R analogous non-reinsurance financing agreements include contingent loans, securitisations and any other arrangements giving rise to charges on future surplus arising.

A realistic basis life firm means a firm to which PRU 2.1.15 R applies. The application of PRU 2.1.15 R is set out in PRU 2.1.16 R and PRU 2.1.17 R. PRU 2.1.9 R requires that a firm must maintain at all times capital resources equal to or in excess of its capital resources requirement. The enhanced capital requirement forms part of the capital resources requirement for a realistic basis life firm. The with-profits insurance capital component forms part of the enhanced capital requirement which a realistic basis life firm is required to calculate in accordance with PRU 2.1.34 R.

This section sets out rules and guidance as to the methods and assumptions to be used in calculating the with-profits insurance capital component.

The purpose of the with-profits insurance capital component is to supplement the mathematical reserves so as to ensure that a firm holds adequate financial resources for the conduct of its with-profits insurance business. In particular, capital in excess of the mathematical reserves may be needed to ensure that adequate final bonuses can be awarded to policyholders. That is, adequate in the sense that in setting bonuses payable to policyholders the firm pays due regard to the interests of its policyholders and treats them fairly. The mathematical reserves for a realistic basis life firm are not required to include provision for future annual bonuses or final bonuses (PRU 7.3.9 R).

The required procedures are summarised in the flowchart in PRU 7 Annex 1G.

Subordinated debt which is subordinated to policyholder interests (see PRU 2.2.93 R is an example of the sort of capital instrument that may give rise to a component of the WPICC under PRU 7.4.7 R (3). Such instruments are treated as capital under PRU 2.2, subject to the requirements of PRU 2.2.93 R. Under realistic reserving the capital instrument is valued as a realistic liability (PRU 7.4.40 R) and in calculating the risk capital margin such an instrument would be valued at its realistic value in the single event outlined in PRU 7.4.43 R (see also PRU 7.4.162 R). Overall, the effect of PRU 2.2, PRU 7.4.7 R (3) and PRU 7.4.43 R is to enable a firm that obtains subordinated debt to benefit from additional capital resources equal to the face amount of that debt.

SUP 4 (Actuaries) sets out the role and responsibilities of the actuarial function and of the with-profits actuary.

1. (1)

   As part of his duties under SUP 4.3.13 R, the actuary appointed by the firm to perform the actuarial function must calculate the firm's mathematical reserves and, in the context of the calculation of the with-profits insurance capital component, must also:

   1. (a)

      advise the firm's governing body on the methods and assumptions to be used in the calculation of the firm's with-profits insurance capital component;

   2. (b)

      perform that calculation in accordance with the methods and assumptions determined by the firm's governing body; and

   3. (c)

      report to the firm's governing body on the results of that calculation.

2. (2)

   As part of his duties under SUP 4.3.16 G, the with-profits actuary must advise the firm's governing body on the discretion exercised by the firm. In the context of the calculation of the with-profits insurance capital component, the with-profits actuary must also advise the firm's governing body as to whether the methods and assumptions (including the allowance for management actions) used for that calculation are consistent with the firm's Principles and Practices of Financial Management (PPFM - see COB 6.10 ) and with its regulatory duty to treat its customers fairly.

In this section, any reference to a firm's regulatory duty to treat its customers fairly is a reference to the firm's duty under Principle 6 (Customers' interests). This states that a firm must pay due regard to the interests of its customers and treat them fairly.

In this section, any reference to the Principles and Practices of Financial Management (PPFM) is a reference to the requirements in COB 6.10 (Principles and Practices of Financial Management) for firms to establish, maintain and record the principles and practices of financial management according to which the business of its with-profits funds is conducted.

The extent to which a firm requires a separate PPFM for each of its with-profits funds will depend on the firm's circumstances and any relevant representations made by the firm to its with-profits policyholders. In this section, any reference to a firm's PPFM refers to the PPFM which relate to the with-profits fund or the with-profits insurance contracts in question.

PRU 1.4.53 R requires firms to maintain accounting and other records for a minimum of three years, or longer as appropriate. For the purposes of PRU 7.4.17 R, a period of longer than three years will be appropriate for a firm's long-term insurance business. In determining an appropriate time period, a firm should have regard to:

1. (1)

   the detailed guidance on record keeping in PRU 1.4.51 G to PRU 1.4.64 G;

2. (2)

   the nature and term of the firm's long-term insurance contracts; and

3. (3)

   any additional provisions or statutory requirements applicable to the firm or its records.

Some of the changes identified in accordance with PRU 7.4.19 R may have to be notified to the firm's policyholders in accordance with the firm's PPFM.

In calculating the amount of a firm's resilience capital requirement allocated to the non-profit insurance contracts in the with-profits fund, the firm should calculate the amount of resilience capital that would be required if that business were in a stand-alone company owning the assets allocated. The resilience capital requirement for the with-profits insurance business should also be calculated as if it were a stand-alone company. An allocation of the firm's total resilience capital requirement should then be made in a manner that would produce a result materially consistent with an allocation in proportion to the amounts calculated for each part of the business as stand-alone entities.

A firm needs to obtain an implicit item waiver from the FSA in order to bring in an amount under PRU 7.4.24 R (1)(b). For guidance on applying for an implicit item waiver in respect of future surpluses relating to with-profits funds see PRU 2 Annex 2. The amount of any implicit item allocated to a with-profits fund may be defined in the terms of any waiver granted.

The amount of regulatory current liabilities for a with-profits fund refers to the sum of the amounts in (1) and (2) in respect of the fund:

1. (1)

   the amount of 'Total other insurance and non-insurance liabilities'; and

2. (2)

   the amount of 'Cash bonuses which had not been paid to policyholders prior to the end of the financial year';

as disclosed at lines 49 and 12 respectively of the appropriate Form 14 ('Long-term business liabilities and margins') for that fund as part of the Annual Returns required to be deposited with the FSA under IPRU(INS) rule 9.6(1).

In PRU 7.4.33 R (1)(d), where a derivative or quasi-derivative has a positive asset value, credit should be given within the realistic value of assets. If the derivative or quasi-derivative has a negative asset value it should be valued within realistic liabilities as an element of realistic current liabilities (see PRU 7.4.40 R (3)).

Where a firm identifies shares in a related undertaking which carries on long-term insurance business as shares held in one of its with-profits funds, PRU 7.4.33 R (1)(e), PRU 7.4.33 R (2) and PRU 7.4.33 R (3) bring in a realistic valuation of the related undertaking equal to its net assets plus the present value of future profits, less its regulatory capital requirements (see PRU 7.4.33 R (3)(v), (vi) and (vii)). Where the related undertaking has taken the present value of future profits arising from its contracts into consideration in covering its regulatory capital requirements (for example, its risk capital margin, under PRU 7.4.45 R (2)(c)), PRU 7.4.33 R (3)(b)(iii) requires a firm to exclude those future profits in valuing the related undertaking. The subtraction of the capital requirements in the calculation provides a straightforward method of allowing for the change in the related undertaking's value in stress conditions, as the value of the related undertaking is not subject to the realistic stress tests of the risk capital margin. In calculating the present value of future profits on non-profit insurance business written in the related undertaking under PRU 7.4.33 R (3)(b)(iii), a firm may value the release of capital requirements as the business runs off (see PRU 7.4.38 G). PRU 7.4.33 R (3)(b)(viii) ensures that any such capital is not double-counted.