Prudential Regulation Authority Rulebook

2.1

Article 77(2) of the Directive requires technical provisions to be calculated using ‘realistic assumptions and adequate methods’.  Article 77(3) and the expected associated provisions in the Delegated Acts extend this requirement to the calculation of the risk margin.

2.2

The PRA considers the risk margin to be a significant part of the technical provisions calculation, so it is important that firms consider whether the methods used there are in fact adequate. This should include consideration of the underlying assumptions.

2.3

For example, firms should not approximate the future Solvency Capital Requirements used to calculate the risk margin as proportional to the projected best estimate unless this has been shown not to lead to a material misstatement of technical provisions.

2.4

Many firms use reserving methods that project forwards from historical data. On its own, this is unlikely to satisfy the Directive requirement for a probability-weighted average of future cash-flows, since not all possible future cash-flows – or the events that cause them – may be represented in the data.

2.5

Although these events are sometimes referred to as ‘binary events’ or ‘extreme events’, such terms suggest that events not found in the data are necessarily extreme or rare. This is not the case, so the PRA prefers to use the term ‘events not in data’, or ENID.

2.6

Firms should take ENID into account when calculating technical provisions. Applying a simple percentage uplift without justification is not an adequate method.

2.7

Where outliers are removed from the data as part of the reserving process, this removes events from the data. Firms should make an allowance for this in the technical provisions calculation unless they have shown that it would not be possible for these, or similar, events to occur again in future.

2.8

Many firms use business plan loss ratios to set the level of premium provisions. Using optimistic business plan loss ratios for this purpose is not realistic, and will not produce a best estimate as required by Article 77 of the Directive.

2.9

A number of firms have approximated an aspect of the technical provisions calculation on grounds of materiality. Where this is the case, firms should quantify the materiality. Where firms make a number of such approximations, their cumulative materiality should also be considered; it is not adequate simply to demonstrate that each aspect taken alone is immaterial.

2.10

For example, where firms have assumed that the impact of lapses on technical provisions is not material, they should quantify the materiality, and consider this together with the impact of other simplifying assumptions made.