PRU Integrated Prudential sourcebook

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PRU 1

Application and general requirements

PRU 1.1

to follow

01/10/2005

to follow

PRU 1.2

Adequacy of financial resources

01/10/2005

Application

PRU 1.2.1

This section applies to an insurer unless PRU 1.2.7 R applies.

31/12/2004

PRU 1.2.2

(1) In relation to liquidity risk only, this section applies to a firm in PRU 1.2.3 R unless PRU 1.2.7 R applies.
(2) Liquidity risk includes the systems, processes and resources required by this section in respect of liquidity risk.

31/12/2004

PRU 1.2.3

The firms referred to in PRU 1.2.2 R (1) are:

(1) a building society;
(2) a bank or an own account dealer (other than a venture capital firm) that is a UK firm;
(3) an incoming EEA firm which:

(a) is a full BCD credit institution; and
(b) has a branch in the United Kingdom;

(4) an overseas firm which is a bank or an own account dealer (other than a venture capital firm) but which is not:

(a) an incoming EEA firm; or
(b) a lead-regulated firm;

(5) an overseas firm which:

(a) is a bank;
(b) is a lead-regulated firm;
(c) is not an incoming EEA firm; and
(d) has a branch in the United Kingdom.

31/12/2004

PRU 1.2.4

For a firm described in PRU 1.2.3 R (3) or PRU 1.2.3 R (5), this section applies only with respect to the branch.

31/12/2004

PRU 1.2.5

This section applies to an incoming EEA firm only to the extent that the relevant matter is not reserved by the relevant Single Market Directive to the firm's Home State regulator.

31/12/2004

PRU 1.2.6

If a firm carries on:

(1) long-term insurance business; and
(2) general insurance business;

this section applies separately to each type of business.

31/12/2004

PRU 1.2.7

This section does not apply to:

(1) a non-directive friendly society; or
(2) a Swiss general insurer; or
(3) an EEA-deposit insurer; or
(4) a UCITS qualifier; or
(5) an ICVC; or
(6) an incoming EEA firm (unless PRU 1.2.3 R applies); or
(7) an incoming Treaty firm.

31/12/2004

PRU 1.2.8

The guidance in PRU 1.2 is drafted with respect to a firm to which PRU 1.2 and the other provisions of PRU referred to in PRU 1.2 apply in full. The guidance in PRU 1.2 is also applicable to a firm that falls into PRU 1.2.2 R. However the guidance in PRU 1.2, as it applies to such a firm, should be read accordingly. In particular, the guidance in PRU 1.2 only applies to such a firm in respect of liquidity risk.

31/12/2004

PRU 1.2.9

In the case of an incoming EEA firm that is a full BCD credit institution and of an overseas firm that is a lead-regulated firm, PRU 1.2 only applies to its United Kingdom branch. However, as a branch is not itself a legal entity separate from the rest of a firm, this restriction does not mean that the rest of the firm can necessarily be left out of account when considering compliance with PRU 1.2. For example, the availability of the branch's liquidity resources may be affected by general liquidity problems in the firm. Likewise, there may be liquidity resources elsewhere in the firm that are available to meet liquidity problems in the branch.

31/12/2004

PRU 1.2.10

One factor that may affect the degree to which it is necessary to take into account the firm as a whole is the extent to which the firm manages the liquidity of the branch on an autonomous basis, or includes the branch within integrated liquidity management of the firm as a whole. In the latter case, for instance, the requirement in PRU 1.2.35 R to carry out scenario analyses may be satisfied by the firm meeting similar requirements set by the regulator in its home country in respect of the firm as whole, provided that the firm separately identifies the impacts on the United Kingdom branch of the scenarios analysed. However, in the case of a full BCD credit institution, the application of PRU 1.2 is further restricted by PRU 1.2.5 R.

31/12/2004

PRU 1.2.11

The scope of application of PRU 1.2 is not restricted to firms that are subject to the relevant EC Directives. It applies, for example, to pure reinsurers.

31/12/2004

PRU 1.2.12

The adequacy of a firm's financial resources needs to be assessed in relation to all the activities of the firm and the risks to which they give rise.

31/12/2004

PRU 1.2.13

The requirements in PRU 1.2 apply to a firm on a solo basis.

31/12/2004

Purpose

PRU 1.2.14

This section amplifies Principle 4, under which a firm must maintain adequate financial resources. It is concerned with the adequacy of the financial resources which a firm needs to hold in order to be able to meet its liabilities as they fall due. These resources include both capital and liquidity resources. PRU 2 sets out provisions relating to the adequacy of capital resources. PRU 5 contains provisions relating to liquidity.

31/12/2004

PRU 1.2.15

This section therefore introduces rules requiring a firm to identify and assess risks to its being able to meet its liabilities as they fall due, how it intends to deal with those risks, and the amount and nature of financial resources the firm considers necessary. These assessments should be documented so that they can be easily reviewed by the FSA as part of the FSA's assessment of the adequacy of capital resources.

31/12/2004

PRU 1.2.16

This section also introduces rules requiring a firm to carry out appropriate stress tests and scenario analyses for the risks it has previously identified and to establish the amount of financial resources needed in each of the circumstances and events considered in carrying out the stress tests and scenario analyses.

31/12/2004

PRU 1.2.17

The adequacy of a firm's capital resources needs to be assessed both by the firm and the FSA. This is done, by the FSA, through comparing the firm's capital resource requirements with its capital resources and by review of a firm's processes and systems for assessing capital needs, the results of the firm's assessments, and other information available to the FSA on the risks faced by the firm.

31/12/2004

Outline of other related provisions

PRU 1.2.18

PRU 2.1 sets out the minimum capital resources requirements for a firm. PRU 2.2 sets out how capital resources are defined and measured for the purpose of meeting the requirements of PRU 2.1.

31/12/2004

PRU 1.2.19

PRU 2.3 sets out detailed guidance on how firms could assess the adequacy of their capital resources both to comply with the rules set out in this section and to enable the FSA to assess better whether the minimum capital resources requirements of PRU 2.1 are appropriate. The more thorough, objective, and prudent a firm's capital assessment is and can be demonstrated as being, the more reliance the FSA will be able to place on the results of that assessment. The FSA will consider the appropriateness of the firm's capital assessment to establish the level of capital resources the firm needs. This may result in the FSA's assessment of a firm's capital resources needs being lower or higher than would otherwise be the case.

31/12/2004

PRU 1.2.20

PRU 5.1 sets out general systems and controls provisions for liquidity risk.

31/12/2004

PRU 1.2.21

PRU 1.4 sets out rules and guidance on the establishment and maintenance of systems and controls.

31/12/2004

Main Requirements

PRU 1.2.22

A firm must at all times maintain overall financial resources, including capital resources and liquidity resources, which are adequate, both as to amount and quality, to ensure that there is no significant risk that its liabilities cannot be met as they fall due.

31/12/2004

PRU 1.2.23

The liabilities referred to in PRU 1.2.22 R include contingent and prospective liabilities that a firm has potentially incurred. It therefore excludes liabilities that might arise from transactions that a firm has not entered into and which it could avoid, for example, by ceasing to trade. It includes liabilities or costs that arise as a consequence of strategies other than continuing as a going concern. It also includes claims that could be made against a firm, which ought to be paid in accordance with fair treatment of customers, even if such claims could not be legally enforced.

31/12/2004

PRU 1.2.24

A firm should therefore make its assessment of adequate financial resources on realistic valuation bases for assets and liabilities taking into account the actual amounts and timing of cash flows under realistic adverse projections. This does not require a firm to hold financial resources sufficient to ensure that any particular margin of financial resources is maintained under such adverse projections.

31/12/2004

PRU 1.2.25

Risks may be addressed through holding capital to absorb losses that unexpectedly materialise. The ability to pay liabilities as they fall due also requires liquidity. Therefore, in assessing the adequacy of a firm's financial resources, both capital and liquidity needs should be considered. PRU 5.1.86 E is an evidential provision relating to PRU 1.2.22 R concerning contingency funding plans. A firm should also consider the quality of its financial resources such as the loss-absorbency of different types of capital and the time required to liquidate different types of asset.

31/12/2004

PRU 1.2.26

A firm must carry out regular assessments of the adequacy of its financial resources using processes and systems which comply with PRU 1.2.27 R.

31/12/2004

PRU 1.2.27

The processes and systems required by PRU 1.2.26 R must be proportionate to the nature, scale and complexity of the firm's activities.

31/12/2004

PRU 1.2.28

PRU 1.2.27 R amplifies the requirement in SYSC 3.2.6 R.

31/12/2004

PRU 1.2.29

The processes and systems are required for a firm's internal assessment of the adequacy of its financial resources. The appropriateness of the internal process, and the degree of involvement of senior management in the process, will be taken into account by the FSA when reviewing a firm's assessment as part of the FSA's own assessment of the adequacy of a firm's financial resources. The processes and systems should ensure that the assessment of the adequacy of a firm's financial resources is reported to its senior management as often as is necessary. In addition, a firm would be expected to reassess the adequacy of its financial resources should the firm experience some material change to the nature or scale of its activities.

31/12/2004

PRU 1.2.30

The assessments undertaken by firms in run-off may not need to be as comprehensive or frequent compared to a firm not in run off since this may better reflect the reduced nature and complexity of its business and reduced access to new capital. Whilst a firm in run-off will still need to carefully monitor the progress of the run off, a more comprehensive assessment may only be appropriate on commencement of the run off or when considering a reduction in capital through the payment of a dividend or other capital distribution or if the firm's circumstances change materially.

31/12/2004

PRU 1.2.31

The processes and systems required by PRU 1.2.26 R must enable the firm to identify the major sources of risk to its ability to meet its liabilities as they fall due, including the major sources of risk in each of the following categories:

(1) credit risk;
(2) market risk;
(3) liquidity risk;
(4) operational risk; and
(5) insurance risk.

31/12/2004

PRU 1.2.32

In PRU 1.2.31 R:

(1) operational risk refers to the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events; and
(2) insurance risk refers to the inherent uncertainties as to the occurrence, amount and timing of insurance liabilities.

31/12/2004

PRU 1.2.33

The processes and systems required by PRU 1.2.26 R must enable the firm to carry out an assessment of how it intends to deal with each of the major sources of risk identified in accordance with PRU 1.2.31 R.

31/12/2004

PRU 1.2.34

Certain risks such as systems and controls weaknesses may not be adequately addressed by, for example, holding additional capital and a more appropriate response would be to rectify the weakness. In such circumstances, the amount of financial resources required to address these risks might be zero. However, a firm should consider whether holding additional capital might be an appropriate response until the identified weaknesses are rectified. The firm must, in accordance with PRU 1.2.37 R, document the approaches taken to manage these risks.

31/12/2005
Past version of PRU 1.2.34 before 31/12/2005

PRU 1.2.35

For each of the major sources of risk identified in accordance with PRU 1.2.31 R, the firm must carry out stress tests and scenario analyses that are appropriate to the nature of those major sources of risk, as part of which the firm must:

(1) take reasonable steps to identify an appropriate range of realistic adverse circumstances and events in which the risk identified crystallises; and
(2) estimate the financial resources the firm would need in each of the circumstances and events considered in order to be able to meet its liabilities as they fall due.

31/12/2004

PRU 1.2.36

Stress tests and scenario analyses should be carried out at least annually. A firm should, however, consider whether the nature of the major sources of risks identified by it in accordance with PRU 1.2.31 R and their possible impact on its financial resources suggest that such tests and analyses should be carried out more frequently. For instance, a sudden change in the economic outlook may prompt a firm to revise the parameters of some of its stress tests and scenario analyses. Similarly, if a firm has recently become exposed to a particular sectoral concentration, it may wish to add some stress tests and scenario analyses in order to reflect that concentration. PRU 5.1.61 E is an evidential provision relating to PRU 1.2.35 R concerning scenario analysis in relation to liquidity risk.

31/12/2004

PRU 1.2.37

A firm must make a written record of its assessment of the adequacy of its financial resources, including:

(1) the major sources of risk identified in accordance with PRU 1.2.31 R;
(2) how it intends to deal with those risks; and
(3) details of the stress tests and scenario analyses carried out and the resulting financial resources estimated to be required in accordance with PRU 1.2.35 R.

31/12/2004

PRU 1.2.38

A firm must retain the records of its assessment of the adequacy of its financial resources for at least three years.

31/12/2004

PRU 1.2.39

Where a firm follows the guidance set out in PRU 2.3.35 G to PRU 2.3.48 G and assesses the adequacy of the capital resources requirement (CRR) in its particular circumstances as a basis for deciding what financial resources are adequate, it should include this in the documentation produced in accordance with PRU 1.2.37 R.

31/12/2004

Stress tests and scenario analyses

PRU 1.2.40

A large part of the process of managing a firm is based on an understanding of the expected outcomes of its business operations and outside events and the normal variation about these expected outcomes. To gain a comprehensive view of the risks being run by a firm, an analysis of extreme events is also needed. Such analysis may take the form of stress tests and scenario analyses. For example, a firm may normally expect interest rates to increase or decrease by 1 or 2 percentage points due to normal variations in economic conditions. However, in some extreme circumstances, interest rates may change by a much greater amount. The use of stress tests and scenario analyses can give a firm's management a better understanding of the firm's true exposure in extreme circumstances.

31/12/2004

PRU 1.2.41

Stress testing typically refers to shifting the values of individual parameters that affect the financial position of a firm and determining the effect on the firm's business.

31/12/2004

PRU 1.2.42

Scenario analysis typically refers to a wider range of parameters being varied at the same time. Scenario analyses often examine the impact of catastrophic events on the firm's financial position, for example, simultaneous movements in a number of risk categories affecting all of a firm's business operations such as business volumes, investment values and interest rate movements.

31/12/2004

PRU 1.2.43

Scenarios generally could also be considered under three broad categories. For example, changes to the business plan, scenarios that involve changes in business cycles and those relating to extreme events. The scenarios can be derived in a variety of ways including stochastic models, analysis of historic experience or a repetition of an historical event. Scenarios can be developed with varying degrees of precision and depth.

31/12/2004

PRU 1.2.44

Both stress tests and scenario analyses can be undertaken by firms to further a better understanding of the vulnerabilities that they face under extreme conditions. They are based on the analysis of the impact of unlikely, but not impossible, events. These events can be financial, operational, legal or relate to any other risk that might have an economic impact on the firm.

31/12/2004

PRU 1.2.45

PRU 1.2.35 R requires a firm, as part of carrying out stress tests and scenario analyses, to take reasonable steps to identify an appropriate range of realistic circumstances and events in which a risk would crystallise. In particular:

(1) a firm need only carry out stress tests and scenario analyses in so far as the circumstances or events are reasonably foreseeable, that is to say, their occurrence is not too remote a possibility; and
(2) a firm should also take into account the relative costs and benefits of carrying out the stress tests and scenario analyses in respect of the circumstances and events identified.

31/12/2004

PRU 1.2.46

The purpose of stress tests and scenario analyses is to test the adequacy of overall financial resources. Scenarios need only be identified, and their impact assessed, in so far as this facilitates that purpose. In particular, the nature, depth and detail of the analysis depend, in part, upon the firm's capital strength and the robustness of its risk prevention and risk mitigation measures.

31/12/2004

PRU 1.2.47

Both stress testing and scenario analyses are prospective analysis techniques, which seek to anticipate possible losses that might occur if an identified risk crystallises. In applying them, a firm needs to decide how far forward to look. This should depend upon:

(1) how quickly it would be able to identify events or changes in circumstances that might lead to a risk crystallising resulting in a loss; and
(2) after it has identified the event or circumstance, how quickly and effectively it could act to prevent or mitigate any loss resulting from the risk crystallising and to reduce exposure to any further adverse event or change in circumstance.

31/12/2004

PRU 1.2.48

The time horizon over which stress tests and scenario analysis would need to be carried out for the market risk arising from the holding of investments, for example, should depend upon:

(1) the extent to which there is a regular, open and transparent market in those assets, which would allow fluctuations in the value of the investment to be more readily and quickly identified; and
(2) the extent to which the market in those assets is liquid (and would remain liquid in the changed circumstances contemplated in the stress test or scenario analysis) which would allow the firm, if needed, to sell its holding so as to prevent or reduce exposure to future price fluctuations.

31/12/2004

PRU 1.2.49

In identifying scenarios, and assessing their impact, a firm should take into account, where material, how changes in circumstances might impact upon:

(1) the nature, scale and mix of its future activities; and
(2) the behaviour of counterparties, and of the firm itself, including the exercise of choices (for example, options embedded in financial instruments or contracts of insurance).

31/12/2004

PRU 1.2.50

In determining whether it would have adequate financial resources in the event of each identified realistic adverse scenario, a firm should:

(1) only include financial resources that could reasonably be relied upon as being available in the circumstances of the identified scenario; and
(2) take account of any legal or other restriction on the purposes for which financial resources may be used.

31/12/2004

PRU 1.2.51

A firm should consider conducting stress tests and scenario analyses which enable it to assess its exposure not only in its current position in the economic and business cycles, but also the possible changes in the cycles which might be expected over, say, the next three to five years.

31/12/2004

PRU 1.2.52

A firm may consider scenarios in which expected future profits will provide capital reserves against future risks. However, it would only be appropriate to take into account profits that can be foreseen with some certainty as arising before the risk against which they are being held could possibly arise. In estimating future reserves, a firm should deduct future dividend payment estimates from projections of future profits.

31/12/2004

PRU 1.2.53

A firm may substitute for traditional stress tests and scenario analyses more sophisticated modelling techniques and this approach is acceptable providing major risks are identified and the modelling has the effect of calculating the effect on a firm's financial position where the risks crystallise or are assumed to crystallise with a particular probability.

31/12/2004

PRU 1.2.54

Additional guidance on stress tests and scenario analyses for the assessment of capital resources is available in PRU 2.3.

31/12/2004

PRU 1.2.55

Additional guidance in relation to stress tests and scenario analysis for liquidity risk is available in PRU 5.1.58 G to PRU 5.1.62 G.

31/12/2004

PRU 1.3

Valuation

01/10/2005

Application

PRU 1.3.1

PRU 1.3 applies to an insurer, unless it is:

(1) a non-directive friendly society; or
(2) an incoming EEA firm; or
(3) an incoming Treaty firm.

31/12/2004

PRU 1.3.2

The scope of application of PRU 1.3 is not restricted to firms that are subject to relevant EC directives. It applies, for example, to pure reinsurers.

31/12/2004

PRU 1.3.3

(1) PRU 1.3 applies to a firm in relation to the whole of its business.
(2) Where a firm carries on both long-term insurance business and general insurance business, PRU 1.3 applies separately to each type of business.

31/12/2004

Purpose

PRU 1.3.4

PRU 1.3 sets out, for the purposes of PRU, rules and guidance as to how a firm should recognise and value assets, liabilities, equity and income statement items. Except where a rule in PRU makes different provision, PRU 1.3 applies whenever a rule in PRU refers to the value or amount of an asset, liability, equity or income statement item.

31/12/2004

General requirements: accounting principles to be applied

PRU 1.3.5

Subject to PRU 1.3.5A R and PRU 1.3.5B R, except where a rule in PRU provides for a different method of recognition or valuation, whenever a rule in PRU refers to an asset, liability, equity or income statement item, a firm must, for the purpose of that rule, recognise the asset, liability, equity or income statement item and measure its value in accordance with:

(1) the insurance accounts rules, or the Friendly Societies (Accounts and Related Provisions) Regulations 1994;
(2) Financial Reporting Standards and Statements of Standard Accounting Practice issued or adopted by the Accounting Standards Board; and
(3) Statements of Recommended Practice, issued by industry or sectoral bodies recognised for this purpose by the Accounting Standards Board; or
(4) international accounting standards;

as applicable to the firm for the purpose of its external financial reporting (or as would be applicable if the firm were a company with its head office in the United Kingdom).

21/04/2005
Past version of PRU 1.3.5 before 21/04/2005

PRU 1.3.5A

For the purposes of PRU, except where a rule in PRU provides for a different method of recognition or valuation, when a firm, upon initial recognition, designates its liabilities as at fair value through profit or loss, it must adjust any value calculated in accordance with PRU 1.3.5 R by subtracting any unrealised gains or adding back in any unrealised losses which are not attributable to changes in a benchmark interest rate.

21/04/2005

PRU 1.3.5B

For the purposes of PRU, except where a rule in PRU provides for a different method of recognition or valuation, in respect of a defined benefit occupational pension scheme:

(1) a firm must derecognise any defined benefit asset;
(2) a firm may substitute for a defined benefit liability the firm's deficit reduction amount.

21/04/2005

PRU 1.3.5C

An election made under PRU 1.3.5B R (2) must be applied consistently for the purposes of PRU in respect of any one financial year.

21/04/2005

PRU 1.3.5D

A firm should keep a record of and be ready to explain to its supervisory contacts in the FSA the reasons for any difference between the deficit reduction amount and any commitment the firm has made in any public document to provide funding in respect of a defined benefit occupational pension scheme.

21/04/2005

PRU 1.3.6

PRU 1.3.5 R provides that unless a rule in PRU provides for a different method of recognition or valuation, the applicable provisions of the Companies Act 1985, the Companies Act (Northern Ireland) Order 1986 or the Friendly Societies (Accounts and Related Provisions) Regulations 1994, as supplemented by Financial Reporting Standards, Statements of Standard Accounting Practice, and Statements of Recommended Accounting Practice, or, where applicable, international accounting standards, should be used to determine the recognition and valuation of assets, liabilities, equity and income statement items for the purposes of PRU, including:

(1) whether, and when, to recognise or de-recognise an asset or liability;
(2) the amount at which to value an asset, liability, equity or income statement item;
(3) which description to place on an asset, liability, equity or income statement item.

21/04/2005
Past version of PRU 1.3.6 before 21/04/2005

PRU 1.3.7

In particular, unless an exception applies, PRU 1.3.5 R should be applied for the purposes of PRU to determine how to account for:

(1) netting of amounts due to or from the firm;
(2) the securitisation of assets and liabilities (see also PRU 1.3.8 G);
(3) leased tangible assets;
(4) assets transferred or received under a sale and repurchase or stock lending transaction; and
(5) assets transferred or received by way of initial or variation margin under a derivative or similar transaction.

31/12/2004

PRU 1.3.8

Where assets or liabilities are securitised, PRU 1.3.5 R only permits de-recognition where Financial Reporting Standard 5 (or, where applicable, International Accounting Standard 39) permits either de-recognition or the linked presentation. However, the FSA will consider granting a waiver to permit de-recognition in other circumstances provided that the firm can demonstrate that securitisation has effectively transferred risk.

21/04/2005
Past version of PRU 1.3.8 before 21/04/2005

PRU 1.3.9

Specific provisions for the methods and assumptions to be used by a firm in calculating its mathematical reserves are made in PRU 7.3.

31/12/2004

PRU 1.3.10

PRU 1.3.5 R implements the requirements of Articles 23.3(viii) and 24.2(iv) of the Consolidated Life Directive. These articles require assets of a firm that are managed on its behalf by a subsidiary undertaking to be taken into account for the purposes of determining the firm's admissible assets and its assets in excess of concentration limits. The application of PRU 1.3.5 R will result in such assets remaining on the balance sheet of the firm.

31/12/2004

Investments, derivatives and quasi-derivatives

PRU 1.3.11

Subject to PRU 1.3.31 R, for the purposes of PRU, a firm must apply PRU 1.3.12 R to PRU 1.3.30 R in order to determine how to account for:

(1) investments that are, or amounts owed arising from the disposal of:

(a) debt securities, bonds and other money- and capital-market instruments; or
(b) loans; or
(c) shares and other variable yield participations; or
(d) units in UCITS schemes, non-UCITS retail schemes, recognised schemes and any other collective investment scheme that invests only in admissible assets (including any derivatives or quasi-derivatives held by the scheme); and

(2) derivatives and quasi-derivatives.

31/12/2004

Marking to market

PRU 1.3.12

Wherever possible, a firm must use mark to market in order to measure the value of the investments referred to in PRU 1.3.11 R. Marking to market is valuation at readily available close out prices from independent sources.

31/12/2004

PRU 1.3.13

For the purposes of PRU 1.3.12 R, examples of readily available close out prices include exchange prices, screen prices, or quotes from several independent reputable brokers.

31/12/2004

PRU 1.3.14

When marking to market, a firm must use the more prudent side of bid/offer price unless the firm is a significant market maker in a particular position type and it can close out at the mid-market price.

31/12/2004

Marking to model

PRU 1.3.15

Where marking to market is not possible, a firm must use mark to model in order to measure the value of the investments referred to in PRU 1.3.11 R. Marking to model is any valuation which has to be benchmarked, extrapolated or otherwise calculated from a market input.

31/12/2004

PRU 1.3.16

When the model used is developed by the firm, that model must be:

(1) based on appropriate assumptions which have been assessed and challenged by suitably qualified parties independent of the development process; and
(2) independently tested, including validation of the mathematics, assumptions, and software implementation.

31/12/2004

PRU 1.3.17

A firm must ensure that its senior management are aware of the positions which are subject to mark to model and understand the materiality of the uncertainty this creates in the reporting of the performance of the business of the firm and the risks to which it is subject.

31/12/2004

PRU 1.3.18

A firm must source market inputs in line with market prices so far as possible and assess the appropriateness of the market inputs for the position being valued and the parameters of the model on each valuation date.

31/12/2004

PRU 1.3.19

A firm must use generally accepted valuation methodologies for particular products where these are available.

31/12/2004

PRU 1.3.20

A firm must establish formal change control procedures, hold a secure copy of the model, and periodically use that model to check valuations.

31/12/2004

PRU 1.3.21

A firm must ensure that its risk management functions are aware of the weakness of the models used and how best to reflect those in the valuation output.

31/12/2004

PRU 1.3.22

A firm must periodically review the model to determine the accuracy of its performance.

31/12/2004

PRU 1.3.23

Examples of periodical review are assessing the continued appropriateness of the assumptions and comparison of actual close out values to model inputs.

31/12/2004

Independent price verification

PRU 1.3.24

In addition to marking to market or marking to model, a firm must perform independent price verification. This is the process by which market prices or model inputs are regularly verified for accuracy and independence.

31/12/2004

PRU 1.3.25

For independent price verification, where independent pricing sources are not available or pricing sources are more subjective, for example, only one available broker quote, prudent measures such as valuation adjustments may be appropriate.

31/12/2004

Valuation adjustments or reserves

PRU 1.3.26

A firm must establish and maintain procedures for considering valuation adjustments or reserves. These procedures must be compliant with the requirements set out in PRU 1.3.29 R.

31/12/2004

PRU 1.3.27

A firm using third-party valuations, or marking to model, must consider whether valuation adjustments are necessary.

31/12/2004

PRU 1.3.28

A firm must consider the need for establishing reserves for less liquid positions and, on an ongoing basis, review their continued appropriateness in accordance with the requirements set out in PRU 1.3.29 R.

31/12/2004

PRU 1.3.29

The requirements referred to in PRU 1.3.26 R and PRU 1.3.28 R are:

(1) a firm must consider the following adjustments or reserves: unearned credit spreads, close-out costs, operational risks, early termination, investing and funding costs, future administrative costs and, where appropriate, model risk; and
(2) a firm must consider several factors when determining whether a valuation reserve is necessary for less liquid items. These factors include the amount of time it would take to hedge out the position/risks within the position; the average and volatility of bid/offer spreads; the availability of market quotes (number and identity of market makers); and the average and volatility of trading volumes.

31/12/2004

Valuation adjustments or reserves

PRU 1.3.30

If the result of establishing adjustments or reserves under PRU 1.3.26 R to PRU 1.3.29 R is a valuation which differs from the fair value determined in accordance with PRU 1.3.5 R , a firm must reconcile the two valuations.

21/04/2005
Past version of PRU 1.3.30 before 21/04/2005

Shares in, and debts due from, related undertakings

PRU 1.3.31

PRU 1.3.11 R does not apply to shares in, and debts due from, a related undertaking that is:

(1) a regulated related undertaking; or
(2) an ancillary services undertaking; or
(3) any other subsidiary undertaking, the shares of which a firm elects to value in accordance with PRU 1.3.35 R.

31/12/2004

PRU 1.3.32

The effect of PRU 1.3.31 R is that shares in, and debts due from, related undertakings of the types referred to are not valued on a mark to market basis. As a result, debts due from these undertakings, and shares in related undertakings which are ancillary services undertakings, are valued at their accounting book value in accordance with PRU 1.3.5 R. Shares in related undertakings referred to in PRU 1.3.31 R (1) or (3) are valued in accordance with PRU 1.3.33 R to PRU 1.3.38 R.

31/12/2004

PRU 1.3.33

Except where the contrary is expressly stated in PRU, whenever a rule in PRU refers to shares held in, and debts due from, an undertaking referred to in PRU 1.3.31 R (1) or PRU 1.3.31R (3), a firm must value the shares held in accordance with PRU 1.3.35 R.

31/12/2004

PRU 1.3.34

In relation to shares in, and debts due from, an undertaking referred to in PRU 1.3.31 R (1), PRU 1.3.33 R does not apply for the purposes of PRU 2.2.78 R and PRU 8.3.

31/12/2004

PRU 1.3.35

For the purposes of PRU 1.3.33 R, the value of the shares held in an undertaking referred to in PRU 1.3.31 R (1) or PRU 1.3.31R (3) is the sum of:

(1) the regulatory surplus value of that undertaking; less

(2) for the purposes of PRU 2.2.90 R, the book value of the total investments in the tier one capital resources and tier two capital resources of that undertaking by the firm and its related undertakings; or

(3) for other purposes in PRU, the sum of:

(a) the book value of the investments by the firm and its related undertakings in the tier two capital resources of the undertaking; and

(b) if the undertaking is an insurance undertaking, its ineligible surplus capital and any restricted assets of the undertaking which have been excluded under PRU 8.3.41 R (1).

31/12/2004

PRU 1.3.36

For the purposes of PRU 1.3.35 R (1), the regulatory surplus value of an undertaking referred to in PRU 1.3.31 R (1) or PRU 1.3.31R (3) is, subject to PRU 1.3.37 R, the sum of:

(1) the total capital after deductions of the undertaking; less
(2) the individual capital resources requirement of the undertaking.

31/12/2005
Past version of PRU 1.3.36 before 31/12/2005

PRU 1.3.37

(1) Subject to PRU 1.3.38 R, for the purposes of PRU 1.3.36 R, only the relevant proportion of the:

(a) total capital after deductions of the undertaking; and
(b) individual capital resources requirement of the undertaking;

is to be taken into account.
(2) In (1), the relevant proportion is the proportion of the total number of shares issued by the undertaking held, directly or indirectly, by the firm.

31/12/2005
Past version of PRU 1.3.37 before 31/12/2005

PRU 1.3.38

If the individual capital resources requirement of an undertaking in PRU 1.3.31 R (1) that is a subsidiary undertaking exceeds its total capital after deductions, the full amount of the items referred to in PRU 1.3.37 R (1) are to be taken into account for the purposes of PRU 1.3.36 R.

31/12/2005
Past version of PRU 1.3.38 before 31/12/2005

PRU 1.3.39

For the purposes of PRU 1.3.35 R to PRU 1.3.38 R:

(1) in relation to an undertaking referred to in PRU 1.3.31 R (1):

(a) individual capital resources requirement has the meaning given by PRU 8.3.34 R;
(b) total capital after deductions means:

(i) when used in relation to a regulated related undertaking that is subject to PRU 2.2.14 R, the total capital after deductions (as calculated at stage M of the calculation in PRU 2.2.14 R) of the undertaking; and
(ii) when used in relation to a regulated related undertaking that is not subject to PRU 2.2.14 R, the total capital after deductions calculated as if that undertaking were required to calculate its total capital after deductions in accordance with stage M of the calculation in PRU 2.2.14 R, but with such adjustments being made to secure that the undertaking's calculation of its total capital after deductions complies with the relevant sectoral rules applicable to it; and

(2) in relation to an undertaking referred to in PRU 1.3.31 R (3):

(a) the individual capital resources requirement is zero; and
(b) the total capital after deductions means the total capital after deductions of the undertaking calculated as if the undertaking were an insurance holding company required to calculate its total capital resources in accordance with PRU 2.2.14 R but with such adjustments being made to secure that the undertaking's calculation of its total capital after deductions complies with the sectoral rules for the insurance sector.
(c) [deleted]

31/12/2005
Past version of PRU 1.3.39 before 31/12/2005

PRU 1.3.40

PRU 1.3.35 R to PRU 1.3.39 R set out several different valuation bases for a firm's shares in related undertakings. The regulatory surplus value (defined in PRU 1.3.36 R) measures the related undertaking's own capital surplus or deficit. This is used: (i) in PRU 1.3.35 R as a basis for calculating the impact on the firm's position of its investments in related undertakings; and (ii) in PRU 8.3 as a starting point for the calculation of ineligible surplus capital.

31/12/2004

PRU 1.3.41

PRU 1.3.35 R determines how, for the purposes of the solo capital adequacy calculation of a firm, that firm's capital resources should be adjusted to take into account its investments in related undertakings.

31/12/2004

PRU 1.3.42

The rules that specify how, for the purposes of the adjusted solo capital calculation, a firm must incorporate its related undertakings into its capital resources and capital resources requirement are set out in PRU 8.3.

31/12/2004

Community co-insurance operations: general insurance business

PRU 1.3.43

Where a relevant insurer determines the amount of a liability in order to make provision for outstanding claims under a Community co-insurance operation, then, if the leading insurer has informed the relevant insurer of the amount of the provision made by the leading insurer for such claims, the amount determined by the relevant insurer:

(1) must be at least as great as the amount of the provision made by the leading insurer; or
(2) in a case where it is not the practice in the United Kingdom to make such provision separately, must be sufficient, when all liabilities are taken into account, to include provision at least as great as that made by the leading insurer for such claims;

due regard being had in either case to the proportion of the risk covered by the relevant insurer and by the leading insurer respectively.

31/12/2004

PRU 1.4

Prudential risk management and associated systems and controls

01/10/2005

Application

PRU 1.4.1

PRU 1.4 applies to an insurer unless it is:

(1) a non-directive friendly society; or
(2) an incoming EEA firm; or
(3) an incoming Treaty firm.

31/12/2004

PRU 1.4.2

PRU 1.4 applies to:

(1) an EEA-deposit insurer; and
(2) a Swiss general insurer;

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

31/12/2004

Purpose

PRU 1.4.3

PRU 1.4 sets out some rules and guidance on the establishment and maintenance of systems and controls for the management of a firm's prudential risks. A firm's prudential risks are those that can reduce the adequacy of its financial resources, and as a result may adversely affect confidence in the financial system or prejudice consumers. Some key prudential risks are credit, market, liquidity, operational, insurance and group risk.

31/12/2004

PRU 1.4.4

The purpose of PRU 1.4 is to serve the FSA's regulatory objectives of consumer protection and market confidence. In particular, this section aims to reduce the risk that a firm may pose a threat to these regulatory objectives, either because it is not prudently managed, or because it has inadequate systems to permit appropriate senior management oversight and control of its business.

31/12/2004

PRU 1.4.5

Both adequate financial resources and adequate systems and controls are necessary for the effective management of prudential risks. A firm may hold financial resources to help alleviate the financial consequences of minor weaknesses in its systems and controls (to reflect possible impairments in the accuracy or timing of its identification, measurement, monitoring and control of certain risks, for example). However, financial resources cannot adequately compensate for significant weaknesses in a firm's systems and controls that could fundamentally undermine its ability to control its affairs effectively.

31/12/2004

How to interpret PRU 1.4

PRU 1.4.6

PRU 1.4 is designed to amplify Principle 3 (Management and control) which requires that a firm take reasonable care to organise and control its affairs responsibly and effectively, with adequate risk management systems. PRU 1.4 is also designed to be complementary to SYSC 2, SYSC 3 and SYSC 3A in that it contains some additional rules and guidance on senior management arrangements and associated systems and controls for firms that could have a significant impact on the FSA's objectives in a prudential context.

31/12/2004

PRU 1.4.7

In addition to supporting PRIN and SYSC, PRU 1.4 lays the foundations for the more specific rules and guidance on the management of credit, market, liquidity, operational, insurance and group risks that are in PRU 3.1, PRU 4.1, PRU 5.1, PRU 6.1, PRU 7.1 and PRU 8.1 respectively. Many of the elements raised here in general terms are expanded upon in these sections.

31/12/2004

PRU 1.4.8

Appropriate systems and controls for the management of prudential risk will vary from firm to firm. Therefore most of the material in PRU 1.4 is guidance. In interpreting this guidance, a firm should have regard to its own particular circumstances. Following from SYSC 3.1.2 G, this should include considering the nature, scale and complexity of its business, which may be influenced by factors such as:

(1) the diversity of its operations, including geographical diversity;
(2) the volume and size of its transactions; and
(3) the degree of risk associated with each area of its operation.

31/12/2004

PRU 1.4.9

The guidance contained within this section is not designed to be exhaustive. When establishing and maintaining its systems and controls a firm should have regard not only to other parts of the Handbook, but also to material that is issued by other industry or regulatory bodies.

31/12/2004

The role of systems and controls in a prudential context

PRU 1.4.10

In a prudential context, a firm's systems and controls should provide its senior management with an adequate means of managing the firm. As such, they should be designed and maintained to ensure that senior management is able to make and implement integrated business planning and risk management decisions on the basis of accurate information about the risks that the firm faces and the financial resources that it has.

31/12/2004

The prudential responsibilities of senior management and the apportionment of those responsibilities

PRU 1.4.11

Ultimate responsibility for the management of prudential risks rests with a firm's governing body and relevant senior managers, and in particular with those individuals that undertake the firm's governing functions and the apportionment and oversight function. In particular, these responsibilities should include:

(1) overseeing the establishment of an appropriate business plan and risk management strategy;
(2) overseeing the development of appropriate systems for the management of prudential risks;
(3) establishing adequate internal controls; and
(4) ensuring that the firm maintains adequate financial resources.

31/12/2004

The delegation of responsibilities within the firm

PRU 1.4.12

Although authority for the management of a firm's prudential risks is likely to be delegated, to some degree, to individuals at all levels of the organisation, overall responsibility for this activity should not be delegated from its governing body and relevant senior managers.

31/12/2004

PRU 1.4.13

Where delegation does occur, a firm should ensure that appropriate systems and controls are in place to allow its governing body and relevant senior managers to participate in and control its prudential risk management activities. The governing body and relevant senior managers should approve and periodically review these systems and controls to ensure that delegated duties are being performed correctly.

31/12/2004

Firms subject to risk management on a group basis

PRU 1.4.14

Some firms organise the management of their prudential risks on a stand-alone basis. In some cases, however, the management of a firm's prudential risks may be entirely or largely subsumed within a whole group or sub-group basis.

(1) The latter arrangement may still comply with the FSA's prudential policy on systems and controls if the firm's governing body formally delegates the functions that are to be carried out in this way to the persons or bodies that are to carry them out. Before doing so, however, the firm's governing body should have explicitly considered the arrangement and decided that it is appropriate and that it enables the firm to meet the FSA's prudential policy on systems and controls. The firm should notify the FSA if the management of its prudential risks is to be carried out in this way.
(2) Where the management of a firm's prudential risks is largely, but not entirely, subsumed within a whole group or sub-group basis, the firm should ensure that any prudential issues that are specific to the firm are:

(a) identified and adequately covered by those to whom it has delegated certain prudential risk management tasks; or
(b) dealt with by the firm itself.

31/12/2004

PRU 1.4.15

Any delegation of the management of prudential risks to another part of a firm's group does not relieve it of responsibility for complying with the FSA's prudential policy on systems and controls. A firm cannot absolve itself of such a responsibility by claiming that any breach of the FSA's prudential policy on systems and controls is effected by the actions of a third party firm to whom the firm has delegated tasks. The risk management arrangements are still those of the firm, even though personnel elsewhere in the firm's group are carrying out these functions on its behalf. Thus any references in PRU to what a firm, its personnel and its management should and should not do still apply, and do not need any adjustment to cover the situation in which risk management functions are carried out on a group-wide basis.

31/12/2004

PRU 1.4.16

Where it is stated in PRU that a particular task in relation to a firm's systems and controls should be carried out by a firm's governing body this task should not be delegated to another part of its group. Furthermore, even where the management of a firm's prudential risks is delegated as described in PRU 1.4.14 G, responsibility for its effectiveness and for ensuring that it remains appropriate remains with the firm's governing body. The firm's governing body should therefore keep any delegation under review to ensure that delegated duties are being performed correctly.

31/12/2004

Business planning and risk management

PRU 1.4.17

Business planning and risk management are closely related activities. In particular, the forward-looking assessment of a firm's financial resources needs, and of how business plans may affect the risks that it faces, are important elements of prudential risk management. A firm's business planning should also involve the creation of specific risk policies which will normally outline a firm's strategy and objectives for, as appropriate, the management of its market, credit, liquidity, operational, insurance and group risks and the processes that it intends to adopt to achieve these objectives. PRU 1.4.18 R to PRU 1.4.25 G set out some rules and guidance relating to business planning and risk management in a prudential context (see also SYSC 3.2.17 G, which states that a firm should plan its business appropriately).

31/12/2004

PRU 1.4.18

A firm must take reasonable steps to ensure the establishment and maintenance of a business plan and appropriate systems for the management of prudential risk.

31/12/2004

PRU 1.4.19

When establishing and maintaining its business plan and prudential risk management systems, a firm must document:

(1) an explanation of its overall business strategy, including its business objectives;
(2) a description of, as applicable, its policies towards market, credit (including provisioning), liquidity, operational, insurance and group risk (that is, its risk policies), including its appetite or tolerance for these risks and how it identifies, measures or assesses, monitors and controls these risks;
(3) the systems and controls that it intends to use in order to ensure that its business plan and risk policies are implemented correctly;
(4) a description of how the firm accounts for assets and liabilities, including the circumstances under which items are netted, included or excluded from the firm's balance sheet and the methods and assumptions for valuation;
(5) appropriate financial projections and the results of its stress testing and scenario analysis (see PRU 1.2 Adequacy of financial resources); and
(6) details of, and the justification for, the methods and assumptions used in financial projections and stress testing and scenario analysis.

31/12/2004

PRU 1.4.20

The prudential risk management systems referred to in PRU 1.4.18 R and PRU 1.4.19 R are the means by which a firm is able to:

(1) identify the prudential risks that are inherent in its business plan, operating environment and objectives, and determine its appetite or tolerance for these risks;

(2) measure or assess its prudential risks;

(3) monitor its prudential risks; and

(4) control or mitigate its prudential risks.

PRU 5.1.78 E is an evidential provision relating to PRU 1.4.18 R concerning risk management systems in respect of liquidity risk arising from substantial exposures in foreign currencies.

31/12/2004

PRU 1.4.21

A firm should consider the relationship between its business plan, risk policies and the financial resources that it has available (or can readily access), recognising that decisions made in respect of one element may have consequences for the other two.

31/12/2004

PRU 1.4.22

A firm's business plan and risk management systems should be:

(1) effectively communicated so that all employees and contractors understand and adhere to the procedures related to their own responsibilities;
(2) regularly updated and revised, in particular when there is significant new information or when actual practice or performance differs materially from the documented strategy, policy or systems.

31/12/2004

PRU 1.4.23

The level of detail in a firm's business plan and its approach to the design of its risk management systems should be appropriate to the scale and complexity of its operations, and the nature and degree of risk that it faces.

31/12/2004

PRU 1.4.24

A firm's business plan and systems documentation should be accessible to the firm's management in line with their respective responsibilities and, upon request, to the FSA.

31/12/2004

PRU 1.4.25

PRU 1.4.19 R (5) requires a firm to document its financial projections and the results of its stress testing and scenario analysis. Such financial projections, stress tests and scenario analysis should be used by a firm's governing body and relevant senior managers when deciding upon how much risk the firm is willing to accept in pursuit of its business objectives and how risk limits should be set. Further rules and guidance on stress testing and scenario analysis are outlined in PRU 1.2 (Adequacy of financial resources) and PRU 5.1 (Liquidity risk systems and controls).

31/12/2004

Internal controls: introduction

PRU 1.4.26

Internal controls should provide a firm with reasonable assurance that it will not be hindered in achieving its objectives, or in the orderly and legitimate conduct of its business, by events that may reasonably be foreseen. More specifically in a prudential context, internal controls should be concerned with ensuring that a firm's business plan and risk management systems are operating as expected and are being implemented as intended. The following rule (PRU 1.4.27 R) reflects the importance of internal controls in a prudential context.

31/12/2004

PRU 1.4.27

A firm must take reasonable steps to establish and maintain adequate internal controls.

31/12/2004

PRU 1.4.28

The precise role and organisation of internal controls can vary from firm to firm. However, a firm's internal controls should normally be concerned with assisting its governing body and relevant senior managers to participate in ensuring that it meets the following objectives:

(1) safeguarding both the assets of the firm and its customers, as well as identifying and managing liabilities;
(2) maintaining the efficiency and effectiveness of its operations;
(3) ensuring the reliability and completeness of all accounting, financial and management information; and
(4) ensuring compliance with its internal policies and procedures as well as all applicable laws and regulations.

31/12/2004

PRU 1.4.29

When determining the adequacy of its internal controls, a firm should consider both the potential risks that might hinder the achievement of the objectives listed in PRU 1.4.28 G, and the extent to which it needs to control these risks. More specifically, this should normally include consideration of:

(1) the appropriateness of its reporting and communication lines (see SYSC 3.2.2 G);
(2) how the delegation or contracting of functions or activities to employees, appointed representatives or other third parties (for example outsourcing) is to be monitored and controlled (see SYSC 3.2.3 G to SYSC 3.2.4 G, PRU 1.4.12 G to PRU 1.4.16 G and PRU 1.4.33 G; additional guidance on the management of outsourcing arrangements is also provided in SYSC 3A.9);
(3) the risk that a firm's employees or contractors might accidentally or deliberately breach a firm's policies and procedures (see SYSC 3A.6.3 G);
(4) the need for adequate segregation of duties (see SYSC 3.2.5 G and PRU 1.4.30 G to PRU 1.4.33 G);
(5) the establishment and control of risk management committees (see PRU 1.4.34 G to PRU 1.4.37 G);
(6) the need for risk assessment and the establishment of a risk assessment function (see SYSC 3.2.10 G and PRU 1.4.38 G to PRU 1.4.41 G); and
(7) the need for internal audit and the establishment of an internal audit function and audit committee (see SYSC 3.2.15 G to SYSC 3.2.16 G and PRU 1.4.42 G to PRU 1.4.45 G).

31/12/2004

Internal controls: segregation of duties

PRU 1.4.30

The effective segregation of duties is an important internal control in the prudential context. In particular, it helps to ensure that no one individual is completely free to commit a firm's assets or incur liabilities on its behalf. Segregation can also help to ensure that a firm's governing body receives objective and accurate information on financial performance, the risks faced by the firm and the adequacy of its systems. In this regard, a firm should ensure that there is adequate segregation of duties between employees involved in:

(1) taking on or controlling risk (which could include risk mitigation);
(2) risk assessment (which includes the identification and analysis of risk); and
(3) internal audit.

31/12/2004

PRU 1.4.31

In addition, a firm should normally ensure that no single individual has unrestricted authority to do all of the following:

(1) initiate a transaction;
(2) bind the firm;
(3) make payments; and
(4) account for it.

31/12/2004

PRU 1.4.32

Where a firm is unable to ensure the complete segregation of duties (for example, because it has a limited number of staff), it should ensure that there are adequate compensating controls in place (for example, frequent review of an area by relevant senior managers).

31/12/2004

PRU 1.4.33

Where a firm outsources a controlled function, such as internal audit, it should take reasonable steps to ensure that every individual involved in the performance of this service is independent from the individuals who perform its external audit. This should not prevent services from being undertaken by a firm's external auditors provided that:

(1) the work is carried out under the supervision and management of the firm's own internal staff; and
(2) potential conflicts of interest between the provision of external audit services and the provision of controlled functions are properly managed.

31/12/2004

Internal controls: risk management committees

PRU 1.4.34

In many firms, especially if there are multiple business lines, it is common for the governing body to delegate some tasks related to risk control and management to committees such as asset and liability committees (ALCO), credit risk committees and market risk committees.

31/12/2004

PRU 1.4.35

Where a firm decides to create one or more risk management committee(s), adequate internal controls should be put in place to ensure that these committees are effective and that their actions are consistent with the objectives outlined in PRU 1.4.28 G. This should normally include consideration of the following:

(1) setting clear terms of reference, including membership, reporting lines and responsibilities of each committee;
(2) setting limits on their authority;
(3) agreeing routine reporting and non-routine escalation procedures;
(4) agreeing the minimum frequency of committee meetings; and
(5) reviewing the performance of these risk management committees.

31/12/2004

PRU 1.4.36

The decision to delegate risk management tasks, along with the terms of reference of the committees and their performance, should be reviewed periodically by the firm's governing body and revised as appropriate.

31/12/2004

PRU 1.4.37

The effective use of risk management committees can help to enhance a firm's internal controls. In establishing and maintaining its risk management committees, a firm should consider:

(1) their membership, which should normally include relevant senior managers (such as the head of group risk, head of legal, and the heads of market, credit, liquidity and operational risk, etc.), business line managers, risk management personnel and other appropriately skilled people, for example, actuaries, lawyers, accountants, IT specialists, etc.;
(2) using these committees to:

(i) inform the decisions made by a firm's governing body regarding its appetite or tolerance for risk taking;
(ii) highlight risk management issues that may require attention by the governing body;
(iii) consider risk at the firm-wide level and, within delegated limits, to determine the allocation of risk limits and financial resources across business lines;
(iv) consider how exposures may be unwound, hedged, or otherwise mitigated, as appropriate.

31/12/2004

Internal controls: risk assessment

PRU 1.4.38

Risk assessment is the process through which a firm identifies and analyses (using both qualitative and quantitative methodologies) the risks that it faces. A firm's risk assessment activities should normally include consideration of:

(1) its total exposure to risk at the firm-wide level (that is, its exposure across business lines and risk categories);
(2) capital allocation and the need to calculate risk weighted returns for different business lines;
(3) the potential correlations that can exist between the risks in different business lines; this should also include looking for risks to which a firm's business plan is particularly sensitive, such as interest rate risk, or multiple dealings with the same counterparty;
(4) the use of stress tests and scenario analysis;
(5) whether there are risks inherent in the firm's business that are not being addressed adequately;
(6) the risk adjusted return that the firm is achieving; and
(7) the adequacy and timeliness of management information on market, credit, insurance, liquidity, operational and group risks from the business lines, including risk limit utilisation.

31/12/2004

PRU 1.4.39

In accordance with SYSC 3.2.10 G a firm should consider whether it needs to set up a separate risk assessment function (or functions) that is responsible for assessing the risks that the firm faces and advising its governing body and senior managers on them.

31/12/2004

PRU 1.4.40

Where a firm does decide that it needs a separate risk assessment function, the employees or contractors that carry out this function should not normally be involved in risk taking activities such as business line management (see PRU 1.4.30 G to PRU 1.4.33 G on the segregation of duties).

31/12/2004

PRU 1.4.41

A summary of the results of the analysis undertaken by a firm's risk assessment function (including, where necessary, an explanation of any assumptions that were adopted) should normally be reported to relevant senior managers as well as to the firm's governing body.

31/12/2004

Internal audit

PRU 1.4.42

A firm should ensure that it has appropriate mechanisms in place to assess and monitor the appropriateness and effectiveness of its systems and controls. This should normally include consideration of:

(1) adherence to and effectiveness of, as appropriate, its market, credit, liquidity, operational, insurance, and group risk policies;
(2) whether departures and variances from its documented systems and controls and risk policies have been adequately documented and appropriately reported, including whether appropriate pre-clearance authorisation has been sought for material departures and variances;
(3) adherence to and effectiveness of its accounting policies, and whether accounting records are complete and accurate;
(4) adherence to and effectiveness of its management reporting arrangements, including the timeliness of reporting, and whether information is comprehensive and accurate; and
(5) adherence to FSA rules and regulatory prudential standards.

31/12/2004

PRU 1.4.43

In accordance with SYSC 3.2.15 G and SYSC 3.2.16 G, a firm should consider whether it needs to set up a dedicated internal audit function.

31/12/2004

PRU 1.4.44

Where a firm decides to set up an internal audit function, this function should provide independent assurance to its governing body, audit committee or an appropriate senior manager of the integrity and effectiveness of its systems and controls.

31/12/2004

PRU 1.4.45

In forming its judgements, the person performing the internal audit function should test the practical operation of a firm's systems and controls as well as its accounting and risk policies. This should include examining the adequacy of supporting records.

31/12/2004

Management information

PRU 1.4.46

Many individuals, at various levels of a firm, need management information relating to their activities. However, PRU 1.4.47 G to PRU 1.4.50 G concentrates on the management information that should be available to those at the highest level of a firm, that is, the firm's governing body and relevant senior managers. In so doing PRU 1.4.47 G to PRU 1.4.50 G amplifies SYSC 3.2.11 G to SYSC 3.2.12 G (which outlines the FSA's high level policy on senior management information) by providing some additional guidance on the management information that should be available in a prudential context.

31/12/2004

PRU 1.4.47

The role of management information should be to help a firm's governing body and senior managers to understand risk at a firm-wide level. In so doing, it should help them to:

(1) determine whether a firm is prudently managed with adequate financial resources;
(2) make the decisions that fall within their ambit (for example, the high level business plans, strategy and risk tolerances of the firm); and
(3) oversee the execution of tasks for which they are responsible.

31/12/2004

PRU 1.4.48

A firm should consider what information needs to be made available to its governing body and senior managers. Some possible examples include:

(1) firm-wide information such as the overall profitability and value of a firm and its total exposure to risk;
(2) reports from committees to which the governing body has delegated risk management tasks, if applicable;
(3) reports from a firm's internal audit and risk assessment functions, if applicable, including exception reports, where risk limits and policies have been breached or systems circumvented;
(4) financial projections under expected and abnormal (that is, stressed) conditions;
(5) reconciliation of actual profit and loss to previous financial projections and an analysis of any significant variances;
(6) matters which require a decision from the governing body or senior managers, for example a significant variation to a business plan, amendments to risk limits, the creation of a new business line, etc;
(7) compliance with FSA rules and regulatory prudential standards;
(8) risk weighted returns; and
(9) liquidity and funding requirements.

31/12/2004

PRU 1.4.49

The management information that is provided to a firm's governing body and senior managers should have the following characteristics:

(1) it should be timely, its frequency being determined by factors such as:

(a) the volatility of the business in which the firm is engaged (that is, the speed at which its risks can change);
(b) any time constraints on when action needs to be taken; and
(c) the level of risk that the firm is exposed to, compared to its available financial resources and tolerance for risk;

(2) it should be reliable, having regard to the fact that it may be necessary to sacrifice a degree of accuracy for timeliness; and
(3) it should be presented in a manner that highlights any relevant issues on which those undertaking governing functions should focus particular attention.

31/12/2004

PRU 1.4.50

The production of management and other information may require the collation of data from a variety of separate manual and automated systems. In such cases, responsibility for the integrity of the information may be spread amongst a number of operational areas. A firm should ensure that it has appropriate processes to validate the integrity of its information.

31/12/2004

Record keeping

PRU 1.4.51

SYSC 3.2.20 R requires a firm to take reasonable care to make and retain adequate records. The following policy on record keeping supplements SYSC 3.2.20 R by providing some additional rules and guidance on record keeping in a prudential context. The purpose of this policy is to:

(1) facilitate the prudential supervision of a firm by ensuring that adequate information is available regarding its past/current financial situation and business activities (which includes the design and implementation of systems and controls); and
(2) help the FSA to satisfy itself that a firm is operating in a prudent manner and is not prejudicing the interests of its customers or market confidence.

31/12/2004

PRU 1.4.52

In addition to the record keeping requirements in PRU, a firm should remember that it may be obliged, under other applicable laws or regulations, to keep similar or additional records.

31/12/2004

PRU 1.4.53

(1) A firm must make and regularly update accounting and other records that are sufficient to enable the firm to demonstrate to the FSA:

(a) that the firm is financially sound and has appropriate systems and controls;
(b) the firm's financial position and exposure to risk (to a reasonable degree of accuracy); and
(c) the firm's compliance with the rules in PRU.

(2) The records in (1) must be retained for a minimum of three years, or longer as appropriate.

31/12/2004

PRU 1.4.54

A firm should be able to make available the records described in PRU 1.4.53 R within a reasonable timeframe when requested to do so by the FSA.

31/12/2004

PRU 1.4.55

The FSA recognises that not all records are specific to a particular point in time. As such, while it may be appropriate to update some records on a daily or continuous basis, for example expenditure and details of certain transactions, it may not be appropriate to update other records as regularly as this, for example those relating to its business plan and risk policies. A firm should decide how regularly it should update particular records.

31/12/2004

PRU 1.4.56

A firm should decide which records it needs to hold, noting that compliance with PRU 1.4.53 R does not require it to hold records on every single aspect of its activities. Some specific guidance on the types of records that a firm should hold is set out in each of the risk specific sections on systems and controls (see PRU 3.1, PRU 4.1, PRU 5.1, PRU 6.1, PRU 7.1 and PRU 8.1).

31/12/2004

PRU 1.4.57

In deciding which records to hold, a firm should also take into account that failure to keep adequate records could make it harder for it to satisfy the FSA that it is compliant with the rules in PRU, and to defend any enforcement action taken against it.

31/12/2004

PRU 1.4.58

A firm should keep the records required in PRU in an appropriate format and language (in terms of format this could include holding them on paper or in electronic or some other form). However, whatever format or language a firm chooses, SYSC 3.2.20 R requires that records be capable of being reproduced on paper and in English (except where they relate to business carried on from an establishment situated in a country where English is not an official language).

31/12/2004

PRU 1.4.59

In accordance with SYSC 3.2.20 R, a firm should retain the records that it needs to comply with PRU 1.4.53 R for as long as they are relevant for the purposes for which they were made.

31/12/2004

PRU 1.4.60

A firm must keep the records required in PRU 1.4.53 R in the United Kingdom, except where:

(1) they relate to business carried on from an establishment in a country or territory that is outside the United Kingdom; and
(2) they are kept in that country or territory.

31/12/2004

PRU 1.4.61

When a firm keeps the records required in PRU 1.4.53 R outside the United Kingdom, it must periodically send an adequate summary of those records to the United Kingdom.

31/12/2004

PRU 1.4.62

Where a firm outsources the storage of some or all of its records to a third party service provider, it should ensure that these records are readily accessible and can be reproduced within a reasonable time period. The firm should also ensure that these records are stored in compliance with the rules and guidance on record keeping in PRU. Additional guidance on the management of outsourcing agreements is provided in SYSC 3A.

31/12/2004

PRU 1.4.63

A firm may rely on records that have been produced by a third party (for example, another group company or an external agent, such as an outsource service provider). However where the firm does so it should ensure that these records are readily accessible and can be reproduced within a reasonable time period. The firm should also ensure that these records comply with the rules and guidance on record keeping in PRU.

31/12/2004

PRU 1.4.64

In accordance with SYSC 3.2.21 G, a firm should have adequate systems and controls for maintaining the security of its records so that they are reasonably safeguarded against loss, unauthorised access, alteration or destruction.

31/12/2004

PRU 1.5

to follow

01/10/2005

to follow

PRU 1.6

to follow

01/10/2005

to follow

PRU 1.7

to follow

01/10/2005

to follow

PRU 1.8

Actions for damages

01/10/2005

PRU 1.8.1

A contravention of the rules in PRU does not give rise to a right of action by a private person under section 150 of the Act (and each of those rules is specified under section 150(2) of the Act as a provision giving rise to no such right of action).

11/08/2004

Export chapter as

Legal Instruments that change this Chapter Application and general requirements

PRU 2

Capital

PRU 2.1

Calculation of capital resources requirements

01/10/2005

Application

PRU 2.1.1

PRU 2.1 applies to an insurer unless it is:

(1) a non-directive friendly society; or
(2) a Swiss general insurer; or
(3) an EEA-deposit insurer; or
(4) an incoming EEA firm; or
(5) an incoming Treaty firm.

31/12/2004

PRU 2.1.2

The scope of application of PRU 2.1 is not restricted to firms that are subject to the relevant EC Directives. It applies, for example, to pure reinsurers.

31/12/2004

PRU 2.1.3

(1) PRU 2.1 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, PRU 2.1 applies separately to each type of business.

31/12/2004

PRU 2.1.4

The adequacy of a firm's capital resources needs to be assessed in relation to all the activities of the firm and the risks to which they give rise.

31/12/2004

PRU 2.1.5

The requirements in PRU 2.1 apply to a firm on a solo basis.

31/12/2004

Purpose

PRU 2.1.6

31/12/2004

PRU 2.1.7

This section (PRU 2.1) sets capital resources requirements for a firm. PRU 2.2 sets out how, for the purpose of this, the amounts or values of capital, assets and liabilities are to be determined. More detailed rules relating to capital, assets and liabilities are also set out in the following chapters and sections:

(1) PRU 1.3 Valuation;
(2) PRU 3 Credit risk;
(3) PRU 4 Market risk;
(4) PRU 5 Liquidity risk;
(5) PRU 6 Operational risk;
(6) PRU 7 Insurance risk; and
(7) PRU 8 Group risk.

PRU 2.1 and PRU 2.2 include appropriate cross-references to these chapters and sections.

31/12/2004

PRU 2.1.8

PRU 2.1 implements minimum EC standards for the capital resources required to be held by a firm undertaking business that falls within the scope of the Consolidated Life Directive (2002/83/EC) or the First Non-Life Directive (73/239/EEC) as amended.

31/12/2004

Main requirements

PRU 2.1.9

(1) A firm must maintain at all times capital resources equal to or in excess of its capital resources requirement (CRR).
(2) A firm which is a participating insurance undertaking and, in relation to its own group capital resources, is in compliance with PRU 8.3.9 R, is deemed to comply with (1).

31/12/2004

PRU 2.1.10

A firm must comply with PRU 2.1.9 R separately in respect of both its long-term insurance business and its general insurance business.

31/12/2004

PRU 2.1.11

In order to comply with PRU 2.1.10 R, a firm carrying on both general insurance business and long-term insurance business will need to allocate its capital resources between its general insurance business and long-term insurance business so that the capital resources allocated to its general insurance business are equal to or in excess of its CRR for its general insurance business and the capital resources allocated to its long-term insurance business are equal to or in excess of its CRR for its long-term insurance business. Whereas long-term insurance assets cannot be used towards meeting a firm's CRR for its general insurance business, surplus general insurance assets may be used towards meeting the CRR for its long-term insurance business (see PRU 7.6.30 R to PRU 7.6.32 G). PRU 7.6 sets out the detailed requirements for the separation of long-term and general insurance business.

31/12/2004

PRU 2.1.12

Firms commonly use different terminology for the various PRU requirements. For example, the MCR is traditionally known as the required minimum margin.

31/12/2004

PRU 2.1.13

The FSA may impose a higher capital requirement than the minimum requirement set out in this section as part of the firm's Part IV permission. (See PRU 2.3).

31/12/2004

Calculation of the CRR

PRU 2.1.14

The CRR for any firm carrying on general insurance business is equal to the MCR in PRU 2.1.21 R.

31/12/2004

PRU 2.1.15

The CRR for any firm to which this rule applies (see PRU 2.1.16 R and PRU 2.1.17 R) is the higher of:

(1) the MCR in PRU 2.1.22 R; and
(2) the ECR in PRU 2.1.34 R.

31/12/2004

PRU 2.1.16

Subject to PRU 2.1.17 R, PRU 2.1.15 R applies to a firm carrying on long-term insurance business, other than:

(1) a non-directive mutual;
(2) a firm which has no with-profits insurance liabilities; and
(3) a firm which has with-profits insurance liabilities that are, and at all times since 31 December 2004 (the coming into force of PRU 2.1.15 R) have remained, less than £500 million.

31/12/2004

PRU 2.1.17

PRU 2.1.15 R also applies to a firm of a type listed in PRU 2.1.16 R (3) if:

(1) the firm makes an election that PRU 2.1.15 R is to apply to it; and
(2) that election is made by written notice given to the FSA in a way that complies with the requirements for written notice in SUP 15.7.

31/12/2004

PRU 2.1.18

The effect of PRU 2.1.16 R (3) is that a firm to which PRU 2.1.15 R applies because it has with-profits insurance liabilities of £500 million or more, will continue to be subject to PRU 2.1.15 R even if its with-profits insurance liabilities fall below £500 million. However, if that happens, it may apply for a waiver from PRU 2.1.15 R under section 148 of the Act. In exercising its discretion under section 148 of the Act, the FSA will have regard (among other factors) to whether there has been a material and permanent change to the firm's business and to the prospects of it continuing to have with-profits insurance liabilities of less than £500 million.

31/12/2004

PRU 2.1.19

A firm that has always had with-profits insurance liabilities of less than £500 million since PRU 2.1.15 R came into force may wish to "opt in" to PRU 2.1.15 R and therefore become a realistic basis life firm. By doing so, it becomes obliged to calculate a with-profits insurance capital component (see PRU 2.1.34 R and PRU 7.4), but it also becomes entitled to certain modifications to the way that a firm is required to calculate its mathematical reserves (see PRU 7.3.46 R and PRU 7.3.76 R). The firm is also then required to report its liabilities on a realistic basis (see IPRU(INS) rule 9.31R(b)). In order to "opt in", the firm must make an election under PRU 2.1.17 R that PRU 2.1.15 R is to apply to it. If a firm that has elected to calculate and report its with-profits insurance liabilities on a realistic basis subsequently decides that it no longer wishes to do so, it may seek to "opt out" by applying for a waiver from PRU 2.1.15 R under section 148 of the Act. In exercising its discretion under section 148 of the Act, the FSA will have regard (among other factors) to whether there has been a material and permanent change to the firm's business and to whether it continues to have with-profits insurance liabilities of less than £500 million.

31/12/2004

PRU 2.1.20

The CRR for a firm carrying on long-term insurance business, but to which PRU 2.1.15 R does not apply, is equal to the MCR in PRU 2.1.22 R.

31/12/2004

Calculation of the MCR

PRU 2.1.21

For a firm carrying on general insurance business, the MCR in respect of that business is the higher of:

(1) the base capital resources requirement for general insurance business applicable to that firm; and
(2) the general insurance capital requirement.

31/12/2004

PRU 2.1.22

For a firm carrying on long-term insurance business, the MCR in respect of that business is the higher of:

(1) the base capital resources requirement for long-term insurance business applicable to that firm; and
(2) the sum of:

(a) the long-term insurance capital requirement; and
(b) the resilience capital requirement.

31/12/2004

PRU 2.1.23

The MCR gives effect to the EC Directive minimum requirements. For general insurance business, the EC Directive minimum is the higher of the general insurance capital requirement and the relevant base capital resources requirement. For long-term insurance business, the EC Directive minimum is the higher of the long-term insurance capital requirement and the base capital resources requirement. The base capital resources requirement is the minimum guarantee fund for the purposes of article 29(2) of the Consolidated Life Directive (2002/83/EC) and article 17(2) of the First Non-Life Directive (73/239/EEC) as amended. The resilience capital requirement is an FSA requirement that is additional to the EC minimum requirement for long-term insurance business.

31/12/2004

PRU 2.1.24

The calculation of the resilience capital requirement is set out in PRU 4.2.

31/12/2004

Calculation of the base capital resources requirement

PRU 2.1.25

The amount of a firm's base capital resources requirement is set out in Table 2.1.26R. If a firm falls within more than one of the descriptions of type of firm set out in Table 2.1.26R, its base capital resources requirement is the highest amount set out against the different types of firm within whose description it falls.

31/12/2005
Past version of PRU 2.1.25 before 31/12/2005

PRU 2.1.26

Table: Base capital resources requirement

Firm type

Amount: Currency equivalent of

General insurance business

Liability insurer

(classes 10-15)

Directive mutual

€2.25 million

Non-directive insurer

€300,000

Other

€3 million

Other insurer

Directive mutual

€1.5 million

Non-directive insurer

(classes 1 to 8, 16 or 18)

€225,000

Non-directive insurer

(classes 9 or 17)

€150,000

Other

€2 million

Long-term insurance business

Mutual

Directive

€2.25 million

Non-directive

€600,000

Any other insurer

€3 million

31/12/2005
Past version of PRU 2.1.26 before 31/12/2005

PRU 2.1.27

(1) Subject to (1A) to (3), the amount of the base capital resources requirement specified in the last column of the table in PRU 2.1.26 R for a firm which is not a non-directive insurer will increase each year, starting on the review date of 20 September 2005 (and annually after that), by the percentage change in the European index of consumer prices (comprising all EU member states, as published by Eurostat) from 20 March 2002, to the relevant review date, rounded up to a multiple of €100,000.

(1A) In the case of a mutual, the amount of the increased base capital resources requirement will be three-quarters of the amount that would apply if it were not a mutual.

(2) In any year, if the percentage change since the last increase is less than 5%, then there will be no increase.

(3) The increase will take effect 30 days after the EU Commission has informed the European Parliament and Council of its review and the increased amount.

31/12/2005
Past version of PRU 2.1.27 before 31/12/2005

PRU 2.1.28

Any increases in the base capital resources requirement referred to in PRU 2.1.27 R will be published on the FSA website.

31/12/2004

PRU 2.1.29

For the purposes of the base capital resources requirement, the exchange rate from the Euro to the pound sterling for each year beginning on 31 December is the rate applicable on the last day of the preceding October for which the exchange rates for the currencies of all the European Union member states were published in the Official Journal of the European Union.

31/12/2004

Calculation of the general insurance capital requirement

PRU 2.1.30

A firm must calculate its general insurance capital requirement as the highest of:

(1) the premiums amount;
(2) the claims amount; and
(3) the brought forward amount.

31/12/2004

PRU 2.1.31

The calculation of each of the premiums amount, claims amount and brought forward amount is set out in PRU 7.2.

31/12/2004

Calculation of the long-term insurance capital requirement

PRU 2.1.32

A firm must calculate its long-term insurance capital requirement as the sum of:

(1) the insurance death risk capital component;
(2) the insurance health risk capital component;
(3) the insurance expense risk capital component; and
(4) the insurance market risk capital component.

31/12/2004

PRU 2.1.33

The calculation of each of the capital components is set out in PRU 7.2.

31/12/2004

Calculation of the ECR

PRU 2.1.34

For a firm carrying on long-term insurance business, the ECR in respect of that business is the sum of:

(1) the long-term insurance capital requirement;
(2) the resilience capital requirement; and
(3) the with-profits insurance capital component.

31/12/2004

PRU 2.1.35

Details of the resilience capital requirement and the with-profits insurance capital component are set out in PRU 4.2 and PRU 7.4 respectively.

31/12/2004

Monitoring requirements

PRU 2.1.36

A firm must at all times monitor whether it is complying with PRU 2.1.9 R and be able to demonstrate that it knows at all times whether it is complying with that rule.

31/12/2004

PRU 2.1.37

For the purposes of PRU 2.1.36 R, a firm should have systems in place to enable it to be certain whether it has adequate capital resources to comply with PRU 2.1.9 R at all times. This does not necessarily mean that a firm needs to measure the precise amount of its capital resources and its CRR on a daily basis. A firm should, however, be able to demonstrate the adequacy of its capital resources at any particular time if asked to do so by the FSA.

31/12/2004

PRU 2.1.38

A firm must notify the FSA immediately of any breach, or expected breach, of PRU 2.1.9 R.

31/12/2004

PRU 2.2

Capital resources

01/10/2005

Application

PRU 2.2.1

PRU 2.2 applies to an insurer unless it is:

(1) a non-directive friendly society; or
(2) a Swiss general insurer; or
(3) an EEA-deposit insurer; or
(4) an incoming EEA firm; or
(5) an incoming Treaty firm.

31/12/2004

Purpose

PRU 2.2.2

PRU 2.1 sets out minimum capital resources requirements for a firm. This section (PRU 2.2) sets out how, for the purpose of these requirements, capital resources are defined and measured. PRU 2.2 also implements minimum EC standards for the composition of capital resources required to be held by a firm undertaking business that falls within the scope of the Consolidated Life Directive (2002/83/EC) or the First Non-Life Directive (73/239/EEC) as amended.

31/10/2004

Principles underlying the definition of capital resources

PRU 2.2.3

The FSA has divided its definition of capital into categories, or tiers, reflecting differences in the extent to which the capital instruments concerned meet the purpose and conform to the characteristics of capital listed in PRU 2.2.5 G. The FSA generally prefers a firm to hold higher quality capital that meets the characteristics of permanency and loss absorbency that are features of tier one capital. Capital instruments falling into core tier one capital can be included in a firm's regulatory capital without limit. Typically, other forms of capital are either subject to limits (see PRU 2.2.16 R to PRU 2.2.26 R) or, in the case of some specialist types of capital, may only be included with the express consent of the FSA (which takes the form of a waiver under section 148 of the Act).

31/10/2004

PRU 2.2.4

Details of the individual components of capital are set out in PRU 2.2.14 R.

31/10/2004

Tier one capital

PRU 2.2.5

Tier one capital typically has the following characteristics:

(1) it is able to absorb losses;
(2) it is permanent;
(3) it ranks for repayment upon winding up after all other debts and liabilities; and
(4) it has no fixed costs, that is, there is no inescapable obligation to pay dividends or interest.

31/10/2004

PRU 2.2.6

The forms of capital that qualify for tier one capital are set out in PRU 2.2.14 R and include, for example, share capital, reserves, verified interim net profits and, for a mutual, the initial fund plus permanent members' accounts. Tier one capital is divided into core tier one capital, perpetual non-cumulative preference shares, and innovative tier one capital.

31/10/2004

Upper and lower tier two capital

PRU 2.2.7

Tier two capital includes forms of capital that do not meet the requirements for permanency and absence of fixed servicing costs that apply to tier one capital. Tier two capital includes, for example:

(1) capital which is perpetual (that is, has no fixed term) but cumulative (that is, servicing costs cannot be waived at the issuer's option, although they may be deferred - for example cumulative preference shares); only perpetual capital instruments may be included in upper tier two capital; and
(2) capital which is not perpetual (that is, it has a fixed term) or which may have fixed servicing costs that cannot generally be either waived or deferred, for example, most subordinated debt. Such capital should normally be of a medium to long-term maturity (that is, an original maturity of at least five years). Dated capital instruments are included in lower tier two capital.

31/12/2005
Past version of PRU 2.2.7 before 31/12/2005

Deductions from capital

PRU 2.2.8

Deductions should be made at the relevant stage of the calculation of capital resources to reflect capital that may not be available to the firm or assets of uncertain value, for example, holdings of intangible assets and assets that are inadmissible for a firm.

31/10/2004

PRU 2.2.9

A full list of deductions from capital resources is shown in PRU 2.2.14 R.

31/12/2004

Calculation of capital resources

PRU 2.2.10

Capital resources can be calculated either as the total of eligible assets less foreseeable liabilities (which is the approach taken in the Insurance Directives) or by identifying the components of capital. Both calculations give the same result for the total amount of capital resources. The approach taken in this section has been to specify the components of capital and the relevant deductions. This is set out in PRU 2.2.14 R. This approach is the same as that used for the calculation of capital resources for banks, building societies and investment firms. A simple example, showing the reconciliation of the two methods, is given in PRU 2.2.11 G.

31/10/2004

PRU 2.2.11

Table: Approaches to calculating capital resources

Liabilities

Assets

Borrowings

100

Admissible assets

350

Ordinary shares

200

Intangible assets

100

Profit and loss account and other reserves

100

Other inadmissible assets

100

Perpetual subordinated debt

150

Total

550

Total

550

Calculation of capital resources: eligible assets less foreseeable liabilities

Total assets

550

less intangible assets

(100)

less inadmissible assets

(100)

less liabilities (borrowings)

(100)

Capital resources

250

Calculation of capital resources: components of capital

Ordinary shares

200

Profit and loss account and other reserves

100

Perpetual subordinated debt

150

less intangible assets

(100)

less inadmissible assets

(100)

Capital resources

250

31/10/2004

PRU 2.2.12

A firm must calculate its capital resources for the purpose of PRU in accordance with PRU 2.2.14 R, subject to the limits in PRU 2.2.16 R to PRU 2.2.26 R.

31/10/2004

PRU 2.2.13

Where PRU 2.2.14 R refers to related text, it is necessary to refer to that text in order to understand fully what is included in the descriptions of capital items and deductions set out in the table.

31/10/2004

PRU 2.2.14

Table: Capital resources (see PRU 2.2.12 R )

Related text

Included in the calculation of capital resources

A √ denotes that the item is included in the calculation of a firm's capital resources: a x denotes that the item is not included in the calculation of a firm's capital resources.

(A) Core tier one capital:

Permanent share capital

PRU 2.2.36 R

√

Profit and loss account and other reserves

PRU 2.2.76 R and PRU 2.2.77 R

√

Share premium account

None

√

Externally verified interim net profits

PRU 2.2.82 R

√

Positive valuation differences

PRU 2.2.78 R

√

Fund for future appropriations

PRU 2.2.81A R

√

(B) Perpetual non-cumulative preference shares

Perpetual non-cumulative preference shares

PRU 2.2.50 R

√

Innovative tier one instruments

PRU 2.2.52 R to PRU 2.2.75 R

√

(D) Total tier one capital before deductions = A + B + C

(E) Deductions from tier one capital:

Investments in own shares

None

√

Intangible assets

PRU 2.2.84 R

√

Amounts deducted from technical provisions for discounting and other negative valuation differences

PRU 2.2.78 R to PRU 2.2.81 R

√

(F) Total tier one capital after deductions = D - E

(G) Upper tier two capital:

Perpetual cumulative preference shares

PRU 2.2.101 R to PRU 2.2.121 R

√

Perpetual subordinated debt

PRU 2.2.101 R to PRU 2.2.121 R

√

Perpetual subordinated securities

PRU 2.2.101 R to PRU 2.2.121 R

√

(H) Lower tier two capital

Fixed term preference shares

PRU 2.2.108 R to PRU 2.2.124 R

√

Fixed term subordinated debt

PRU 2.2.108 R to PRU 2.2.124 R

√

Fixed term subordinated securities

PRU 2.2.108 R to PRU 2.2.124 R

√

(I) Total tier two capital = G + H

(J) Positive adjustments for related undertakings

Related undertakings that are regulated related undertakings (other than insurance undertakings)

PRU 2.2.90 R

√

(K) Total capital after positive adjustments for regulated related undertakings that are not insurance undertakings but before deductions = F + I + J

(L) Deductions from total capital

Inadmissible assets

PRU 2.2.86 R & PRU 2 Annex 1R

√

Assets in excess of market risk and counterparty limits

PRU 3.2.22 R

√

PRU 2.2.89 R

√

Negative adjustments for related undertakings that are regulated related undertakings (other than insurance undertakings)

PRU 2.2.90 R

√

(M) Total capital after deductions = K - L

(N) Other capital resources*:

Unpaid share capital or, in the case of a mutual, unpaid initial funds and calls for supplementary contributions

PRU 2.2.126 G to PRU 2.2.128 G

Implicit items

PRU 2 Annex 2 G

(O) Total capital resources after deductions = M + N

* Items in section (N) of the table can be included in capital resources if subject to a waiver under section 148 of the Act.

31/12/2005
Past version of PRU 2.2.14 before 31/12/2005

Limits on the use of different forms of capital

PRU 2.2.15

As the various components of capital differ in the degree of protection that they offer the firm and its customers, restrictions are placed on the extent to which certain types of capital are eligible for inclusion in a firm's capital resources. These restrictions are set out in PRU 2.2.16 R to PRU 2.2.26 R.

31/10/2004

PRU 2.2.16

At least 50% of a firm's MCR must be accounted for by the sum of:

(1) the amount calculated at stage A of the calculation in PRU 2.2.14 R; and
(2) notwithstanding PRU 2.2.20 R (1), the amount calculated at stage B of the calculation in PRU 2.2.14 R;

less the amount calculated at stage E of the calculation in PRU 2.2.14 R.

31/10/2004

PRU 2.2.17

A firm carrying on long-term insurance business must meet the higher of:

(1) 1/3 of the long-term insurance capital requirement; and
(2) the base capital resources requirement;

with the sum of the items listed at stages A, B, G and H in PRU 2.2.14 R less the sum of the items listed at stage E in PRU 2.2.14 R.

31/12/2005
Past version of PRU 2.2.17 before 31/12/2005

PRU 2.2.18

A firm carrying on general insurance business must meet the higher of:

(1) 1/3 of the general insurance capital requirement; and
(2) the base capital resources requirement;

with the sum of the items listed at stages A, B, G and H in PRU 2.2.14 R less the sum of the items listed at stage E in PRU 2.2.14 R.

31/12/2005
Past version of PRU 2.2.18 before 31/12/2005

PRU 2.2.18A

In PRU 2.2.17 R and PRU 2.2.18 R:

(1) items listed at stage B in PRU 2.2.14 R may be included notwithstanding PRU 2.2.20 R (1);
(2) innovative tier one capital that meets the conditions (other than PRU 2.2.108 R (11)) for it to be included as upper tier two capital at stage G in PRU 2.2.14 R may be treated as an item listed at stage G; and
(3) a firm must exclude from the calculation the higher of the following:

(a) the amount (if any) by which the sum of the items listed at stages G and H in PRU 2.2.14 R exceeds the total (net of deductions) of the remaining constituents of adjusted stage M; and
(b) the amount (if any) by which the sum of the items listed at stage H in PRU 2.2.14 R exceeds one-third of the total (net of deductions) of the remaining constituents of adjusted stage M;

where adjusted stage M means the amount calculated at stage M of the calculation in PRU 2.2.14 R less the amount of any innovative tier one capital that is not treated as upper tier two capital for the purpose of PRU 2.2.17 R or PRU 2.2.18 R, as the case may be.

31/12/2005

PRU 2.2.19

The purposes of the requirements in PRU 2.2.16 R to PRU 2.2.18 R are to comply with the Insurance Directives' requirement that firms maintain a guarantee fund of higher quality capital resources items and to ensure that at least 50% of the firm's capital resources needed to meet its MCR provide maximum loss absorbency to protect the firm from insolvency.

31/10/2004

PRU 2.2.20

In relation to a firm's tier one capital resources calculated at stage F of the calculation in PRU 2.2.14 R:

(1) at least 50% must be accounted for by core tier one capital; and
(2) no more than 15% may be accounted for by innovative tier one capital.

31/10/2004

PRU 2.2.21

The purpose of the requirement in PRU 2.2.20 R (1) is to ensure that at least 50% of the firm's tier one capital resources (net of tier one capital deductions) is met by core tier one capital which provides maximum loss absorbency on a going concern basis to protect the firm from insolvency. Although a perpetual non-cumulative preference share is in legal form a share, it behaves in many ways like a perpetual fixed interest debt instrument. Within the 50% limit on non-core tier one capital, PRU 2.2.20 R (2) places a further sub-limit on the amount of innovative tier one capital that a firm may include in its tier one capital resources. This limit is necessary to ensure that most of a firm's tier one capital comprises items of capital of the highest quality.

31/10/2004

PRU 2.2.22

(1) A firm may, subject to the limits in PRU 2.2.23 R, include in its tier two capital resources any capital item excluded from its tier one capital resources under PRU 2.2.20 R which meets the conditions for it to be included as tier two capital at stage G or H in PRU 2.2.14 R.
(2) For the purpose of (1), the requirement to obtain a legal opinion in PRU 2.2.108 R (11) does not apply.

31/12/2005
Past version of PRU 2.2.22 before 31/12/2005

PRU 2.2.23

Subject to PRU 2.2.24 R, a firm must exclude from the calculation of its capital resources the following:

(1) the amount (if any) by which tier two capital resources exceed the amount calculated at stage F of the calculation in PRU 2.2.14 R; and
(2) the amount (if any) by which lower tier two capital resources exceed 50% of the amount calculated at stage F of the calculation in PRU 2.2.14 R.

31/10/2004

PRU 2.2.24

At least 75% of a firm's MCR must be accounted for by the sum of:

(1) the amount calculated at stage A plus, notwithstanding PRU 2.2.20 R (1), the amount calculated at stage B less the amount calculated at stage E of the calculation in PRU 2.2.14 R; and
(2) the amount calculated at stage G of the calculation in PRU 2.2.14 R.

31/12/2005
Past version of PRU 2.2.24 before 31/12/2005

PRU 2.2.24A

In PRU 2.2.24 R the amount of any innovative tier one capital that meets the conditions for it to be included as upper tier two capital at stage G in PRU 2.2.14 R may be included in the amount calculated at stage G.

31/12/2005

PRU 2.2.25

PRU 2.2.23 R and PRU 2.2.24 R give effect to the Insurance Directives' requirements that a firm's tier two capital resources must not exceed its tier one capital resources and that no more than 25% of a firm's "required solvency margin" should consist of lower tier two capital resources.

31/10/2004

PRU 2.2.26

A firm that carries on both long-term insurance business and general insurance business must apply the limits in PRU 2.2.16 R to PRU 2.2.24 R separately for each type of business.

31/10/2004

Characteristics of tier one capital

PRU 2.2.27

A firm may not include a share in, or another investment in, or external contribution to the capital of, that firm in its tier one capital resources unless it complies with the following conditions:

(1) it is included in one of the categories in PRU 2.2.28 R;
(2) it is not excluded by any of the rules in PRU 2.2; and
(3) it complies with the conditions set out in PRU 2.2.29 R.

31/10/2004

PRU 2.2.28

The categories referred to in PRU 2.2.27 R (1) are:

(1) permanent share capital;
(2) a perpetual non-cumulative preference share; and
(3) an innovative tier one instrument.

31/10/2004

PRU 2.2.29

Subject to PRU 2.2.30 R, an item of capital in a firm complies with PRU 2.2.27 R (3) if:

(1) it is issued by the firm;
(2) it is fully paid and the proceeds of issue are immediately and fully available to the firm;
(3) it:

(a) cannot be redeemed at all or can only be redeemed on a winding up of the firm; or
(b) complies with the conditions in PRU 2.2.38 R and PRU 2.2.39 R;

(4) any coupon is either non-cumulative or, if it is cumulative, it complies with PRU 2.2.40 R;
(5) it is able to absorb losses to allow the firm to continue trading and in the case of an innovative tier one instrument it complies with PRU 2.2.56 R to PRU 2.2.58 R;
(6) it ranks for repayment upon winding up no higher than a share of a company incorporated under the Companies Act 1985 or the Companies (Northern Ireland) Order 1986 (whether or not it is such a share);
(7) the firm is under no obligation to pay a coupon on it in cash at any time; and
(8) the description of its characteristics used in its marketing is consistent with the characteristics required to satisfy PRU 2.2.29 R (1) to PRU 2.2.29 R (7) and, where it applies, PRU 2.2.93 R.

31/12/2005
Past version of PRU 2.2.29 before 31/12/2005

PRU 2.2.30

(1) An item of capital does not comply with PRU 2.2.27 R (3) if the issue of that item of capital by the firm is connected with one or more other transactions which, when taken together with the issue of that item, could produce the effect described in (2).
(2) The effect referred to in (1) is a reduction in the economic benefit intended to be conferred on the firm by the issue of the item of capital which means that the item of capital no longer displays all of the characteristics set out in PRU 2.2.29 R (1) to (8).

31/10/2004

PRU 2.2.31

An item of capital does not comply with PRU 2.2.29 R (5) if the holder of that item does not bear losses to at least the same degree as the holder of a share of a company incorporated under the Companies Act 1985 or the Companies (Northern Ireland) Order 1986 (whether or not it is such a share).

31/12/2004

PRU 2.2.32

PRU 2.2.29 R (2) is stricter than the Companies Act definition of fully paid, which only requires an undertaking to pay.

31/10/2004

PRU 2.2.33

An item of capital does not comply with PRU 2.2.29 R (8) if it is marketed as a capital instrument that would only qualify for a lower level of capital or on the basis that investing in it is like investing in a lower tier two instrument. For example, an undated capital instrument should not be marketed as a dated capital instrument if the terms of the capital instrument include an option by the issuer to redeem the capital instrument at a specified date in the future.

31/10/2004

PRU 2.2.34

For the purposes of PRU 2.2.30 R, examples of connected transactions might include guarantees or any other side agreement provided to the holders of the capital instrument by the firm or a connected party or a related transaction designed, for example, to enhance their security or to achieve a tax benefit, but which may compromise the loss absorption capacity or permanence of the original capital item.

31/12/2004

PRU 2.2.35

A firm may not include a share in its tier one capital resources unless (in addition to complying with the other relevant rules in PRU 2.2):

(1) (in the case of a firm that is a company as defined in the Companies Act 1985 or the Companies (Northern Ireland) Order 1986) it is "called-up share capital" within the meaning given to that term in that Act or, as the case may be, that Order; or
(2) (in the case of any other firm) it is:

(a) in economic terms; and
(b) in its characteristics as capital (including loss absorbency, permanency, ranking for repayment and fixed costs);

substantially the same as called-up share capital falling into (1).

31/10/2004

Core tier one capital: permanent share capital

PRU 2.2.36

Permanent share capital means an item of capital which (in addition to satisfying PRU 2.2.29 R) meets the following conditions:

(1) it is:

(a) an ordinary share; or
(b) a members' contribution; or
(c) part of the initial fund of a mutual;

(2) any coupon on it is not cumulative, and the firm is under no obligation to pay a coupon and has the right to choose the amount of any coupon that it pays; and
(3) the terms upon which it is issued do not permit redemption and it is otherwise incapable of being redeemed to at least the degree of an ordinary share issued by a company incorporated under the Companies Act 1985 or the Companies (Northern Ireland) Order 1986 (whether or not it is such a share).

31/12/2005
Past version of PRU 2.2.36 before 31/12/2005

PRU 2.2.37

PRU 2.2.36 R has the effect that the firm should be under no obligation to make any payment in respect of a tier one instrument if it is to form part of its permanent share capital unless and until the firm is wound up. A tier one instrument that forms part of permanent share capital could not therefore count as a liability before the firm is wound up. The fact that relevant company law permits the firm to make earlier repayment does not mean that the tier one instruments are not eligible. However, the firm should not be required by any contractual or other obligation arising out of the terms of that capital to repay permanent share capital. Similarly a tier one instrument may still qualify if company law allows dividends to be paid on this capital, provided the firm is not contractually or otherwise obliged to pay them. There should therefore be no fixed costs.

31/10/2004

Basic rules about redemption and cumulative coupons

PRU 2.2.38

In relation to a perpetual non-cumulative preference share which is redeemable, a firm may not include it in its tier one capital resources unless its contractual terms are such that:

(1) it is redeemable only at the option of the firm; and
(2) the firm cannot exercise that redemption right:

(a) before the fifth anniversary of its date of issue;
(b) unless it has given notice to the FSA in accordance with PRU 2.2.72 R; and
(c) unless at the time of exercise of that right it complies with PRU 2.1.9 R and will continue to do so after redemption.

31/12/2005
Past version of PRU 2.2.38 before 31/12/2005

PRU 2.2.39

In relation to an innovative tier one instrument which is redeemable and which, either:

(1) is or may become subject to a step-up; or
(2) satisfies PRU 2.2.54 R (2);

a firm may not include it in its tier one capital resources unless it complies with the conditions in PRU 2.2.38 R, except that in PRU 2.2.38 R (2)(a) "fifth anniversary" is replaced by "tenth anniversary".

31/10/2004

PRU 2.2.40

A potential tier one instrument with a cumulative coupon complies with PRU 2.2.29 R (4) only if any such coupon must, if deferred, be paid by the firm in the form of permanent share capital.

31/10/2004

PRU 2.2.41

PRU 2.2.38 R does not apply to permanent share capital because no item of capital that is either redeemable or that has a cumulative coupon can be permanent share capital.

31/12/2004

Further guidance on redemption

PRU 2.2.42

The rules in PRU 2.2 about redemption of potential tier one instruments fall into three classes:

(1) rules defining whether a firm's potential tier one instruments are eligible for inclusion in its tier one capital resources at all;
(2) rules defining whether a firm's potential tier one instruments are eligible for inclusion in its permanent share capital; and
(3) rules defining whether a firm's potential tier one instruments must be classified as innovative tier one instruments.

31/10/2004

PRU 2.2.43

The rules about redemption that are relevant to deciding whether a firm's potential tier one instruments are eligible for inclusion in its tier one capital resources at all are as follows.

(1) PRU 2.2.29 R (3) and PRU 2.2.39 R have the following provisions.

(a) Any capital instrument that is redeemable at the option of the holder cannot form part of a firm's tier one capital resources. Instead, if it is redeemable at all, a capital instrument should only be redeemable at the option of the firm.
(b) A redemption right should be exercisable no earlier than the fifth anniversary of the date of issue. However, if an instrument is an innovative tier one instrument which is subject to a step-up or any other economic incentive to redeem, any such redemption should be exercisable no earlier than the tenth anniversary.
(c) Any redemption proceeds should be payable only in cash or in shares.
(d) The terms of the capital instrument should provide that any redemption right should not be exercised unless and until the firm has given the notice to the FSA required under PRU 2.2.72 R.
(e) Any redemption right should not be exercisable unless both before and after the redemption the firm complies with PRU 2.1.9 R (which requires that a firm has sufficient capital resources to meet its capital resources requirement).

(2) Under PRU 2.2.70 R, a firm should not include a potential tier one instrument that is redeemable in whole or in part in permanent share capital in its tier one capital resources unless the firm has:

(a) sufficient permanent share capital or sufficient authority to issue permanent share capital (and the authority to allot it) to meet any redemption obligations that have become due; and
(b) a prudent reserve of permanent share capital or sufficient authority to issue permanent share capital (and the authority to allot it) to meet possible future redemption obligations.

(3) PRU 2.2.65 R contains limits on the amount of permanent share capital that may be issued on a redemption of a potential tier one instrument redeemable in permanent share capital.

31/10/2004

PRU 2.2.44

The rules defining whether a firm's potential tier one instruments are eligible for inclusion in its permanent share capital are to be found in PRU 2.2.36 R. As far as redemption is concerned, it says that the capital instrument should be no more capable of being redeemed than a share under the Companies Act 1985 or the Companies (Northern Ireland) Order 1986. PRU 2.2.38 R (which sets out the basic rules for redemption) does not apply to permanent share capital as a redeemable potential tier one instrument should not be included in permanent share capital.

31/10/2004

PRU 2.2.45

The rules about redemption that are relevant to deciding whether a firm's potential tier one instruments should be classified as innovative tier one instruments are as follows.

(1) Under PRU 2.2.53 R, a redeemable potential tier one instrument is always treated as an innovative tier one instrument if the redemption proceeds are payable otherwise than in cash.
(2) Under PRU 2.2.54 R, any feature of a tier one instrument that in conjunction with a call would make a firm more likely to redeem it or to have an incentive to do so will make it an innovative tier one instrument.
(3) Under PRU 2.2.62 R a step-up coupled with a right of redemption results in a potential tier one instrument being treated as an innovative tier one instrument.

31/10/2004

Further guidance on coupons

PRU 2.2.46

The rules in PRU 2.2 about the coupons payable on potential tier one instruments fall into the same three classes that apply to the rules on redemption, as set out in PRU 2.2.42 G.

31/10/2004

PRU 2.2.47

The rules about coupons that are relevant to deciding whether a firm's potential tier one instruments are eligible for inclusion in its tier one capital resources at all are as follows.

(1) Under PRU 2.2.29 R (4) and PRU 2.2.40 R, any deferred cumulative coupon should only be payable in permanent share capital. If a cumulative coupon is payable on a potential tier one instrument in another form, it should not be included in the firm's tier one capital resources.
(2) Under PRU 2.2.29 R (7), the firm is not obliged to pay a coupon in cash at any time.
(3) PRU 2.2.63 R says that a potential tier one instrument that may be subject to a step-up that potentially exceeds defined limits should not be included in the firm's tier one capital resources. PRU 2.2.64 R says that any step-up should not arise before the tenth anniversary of the date of issue if it is to be included in the firm's tier one capital resources.
(4) The provisions of PRU 2.2.70 R summarised in PRU 2.2.43 G (2) also apply to the payment of coupons.

31/12/2005
Past version of PRU 2.2.47 before 31/12/2005

PRU 2.2.48

PRU 2.2.36 R (2) says that a capital instrument on which a cumulative coupon is payable must not be included in a firm's permanent share capital. There must be no obligation to pay a coupon and the firm must be able to choose the amount of any coupon paid.

31/12/2005
Past version of PRU 2.2.48 before 31/12/2005

PRU 2.2.49

The rules about coupons that are relevant to deciding whether a firm's potential tier one instruments should be classified as innovative tier one instruments are as follows:

(1) Under PRU 2.2.60 R a potential tier one instrument with a cumulative coupon is an innovative tier one instrument.
(2) Under PRU 2.2.40 R a potential tier one instrument with a coupon that if deferred must be paid in permanent share capital is an innovative tier one instrument.
(3) Under PRU 2.2.62 R a step-up coupled with a right of redemption by the firm results in a potential tier one instrument being treated as an innovative tier one instrument.

31/10/2004

Perpetual non-cumulative preference shares

PRU 2.2.50

A perpetual non-cumulative preference share may be included at stage B of the calculation in PRU 2.2.14 R if:

(1) it complies with PRU 2.2.29 R, PRU 2.2.35 R and PRU 2.2.38 R;
(2) any coupon on it is not cumulative, and the firm is under no obligation to pay a coupon in any circumstances;
(3) it is not excluded from tier one capital resources by any of the rules in PRU 2.2; and
(4) it is not an innovative tier one instrument.

31/12/2005
Past version of PRU 2.2.50 before 31/12/2005

PRU 2.2.51

Perpetual non-cumulative preference shares should be perpetual and redeemable only at the firm's option. Any feature that, in conjunction with a call, would make a firm more likely to redeem perpetual non-cumulative preference shares would normally result in classification as an innovative tier one instrument. Such features would include, but not be limited to, a step-up, bonus coupon on redemption or redemption at a premium to the original issue price of the share.

31/10/2004

Innovative tier one instruments: general rules

PRU 2.2.52

If an item of capital is stated to be an innovative tier one instrument by the rules in PRU 2.2, it cannot be included in stages A or B of the calculation in PRU 2.2.14 R.

31/10/2004

PRU 2.2.53

If a tier one instrument is redeemable at the option of the firm, it is an innovative tier one instrument unless it is redeemable solely in cash.

31/10/2004

PRU 2.2.54

If a tier one instrument:

(1) is redeemable; and
(2) is issued on terms that are (or its terms are amended and the amended terms are) such that a reasonable person would (judging at or around the time of issue or amendment) think that:

(a) the firm is likely to redeem it; or
(b) the firm is likely to have a substantial economic incentive to redeem it;

that tier one instrument is an innovative tier one instrument.

31/10/2004

PRU 2.2.55

Any feature that in conjunction with a call would make a firm more likely to redeem a tier one instrument would normally result in classification as innovative tier one capital resources. Innovative tier one instruments include but are not limited to those incorporating a step-up or principal stock settlement.

31/10/2004

Innovative tier one instruments: loss absorbency

PRU 2.2.56

A capital instrument may only be included in innovative tier one capital resources if a firm's obligations under the instrument either:

(1) do not constitute a liability (actual, contingent or prospective) under section 123(2) of the Insolvency Act 1986; or
(2) do constitute such a liability but the terms of the instrument are such that:

(a) any such liability is not relevant for the purposes of deciding whether:

(i) the firm is, or is likely to become, unable to pay its debts; or
(ii) its liabilities exceed its assets;

(b) a creditor (including, but not limited to, a holder of the instrument) is not able to petition for the winding up or administration of the firm on the grounds that the firm is or may become unable to pay any such liability; and
(c) the firm is not obliged to take into account such a liability for the purposes of deciding whether or not the firm is, or may become, insolvent for the purposes of section 214 of the Insolvency Act 1986 (wrongful trading).

31/10/2004

PRU 2.2.57

The effect of PRU 2.2.56 R is that if a potential tier one instrument does constitute a liability, this should only be the case when the firm is able to pay that liability but chooses not to do so. As tier one capital resources must be undated, this will generally only be relevant on a solvent winding up of the firm.

31/10/2004

PRU 2.2.58

A firm wishing to issue an innovative tier one instrument must obtain a properly reasoned legal opinion from Queen's Counsel or, where the opinion relates to the law of a jurisdiction outside the United Kingdom, from a lawyer in that jurisdiction of equivalent status, confirming that the criteria in PRU 2.2.29 R (5) and PRU 2.2.31 R are met.

31/12/2005
Past version of PRU 2.2.58 before 31/12/2005

PRU 2.2.59

The holder should agree that the firm has no liability (including any contingent or prospective liability) to pay any amount to the extent to which that liability would cause the firm to become insolvent if it made the payment or to the extent that its liabilities exceed its assets or would do if the payment were made. The terms of the capital instrument should be such that the directors can continue to trade in the best interests of the senior creditors even if this prejudices the interests of the holders of the instrument.

31/10/2004

Innovative tier one instruments: Coupons

PRU 2.2.60

A tier one instrument with a cumulative coupon which complies with PRU 2.2.40 R is an innovative tier one instrument.

31/10/2004

PRU 2.2.61

An item of capital does not fall into PRU 2.2.60 R merely because a firm has come under an obligation to pay a particular coupon in permanent share capital where that obligation is the result of a voluntary election by the holder or the firm to be paid the coupon in that form. Thus, for example, if a shareholder of a firm is allowed to elect to be paid a dividend in the form of a conventional scrip dividend, that does not make the share into an innovative tier one instrument.

31/10/2004

Innovative tier one instruments and other tier one instruments: step-ups

PRU 2.2.62

If:

(1) a potential tier one instrument is or may become subject to a step-up; and
(2) that potential tier one instrument is redeemable at any time (whether before, at or after the time of the step-up);

that potential tier one instrument is an innovative tier one instrument.

31/10/2004

PRU 2.2.63

If a potential tier one instrument is or may become subject to a step-up, a firm must not include it in its tier one capital resources if the amount of the step-up as calculated as at the date of issue of the instrument exceeds or may exceed;

(1) 100 basis points; and
(2) 50% of the initial credit spread.

31/12/2005
Past version of PRU 2.2.63 before 31/12/2005

PRU 2.2.64

A firm must not include a potential tier one instrument that is or may become subject to a step-up in its tier one capital resources if the step-up can arise earlier than the tenth anniversary of the date of issue of that item of capital.

31/10/2004

Innovative tier one instruments: principal stock settlement

PRU 2.2.65

A firm must not include a potential tier one instrument that is redeemable in whole or in part in permanent share capital in its tier one capital resources if:

(1) the conversion ratio as at the date of redemption may be greater than the conversion ratio as at the time of issue by more than 200%; or
(2) the issue or market price of the conversion instruments issued in relation to one unit of the original capital item (plus any cash element of the redemption) may be greater than the issue price (or, as the case may be, market price) of that original capital item.

31/10/2004

PRU 2.2.66

In PRU 2.2.65 R to PRU 2.2.69 R:

(1) the original capital item means the capital item that is being redeemed; and
(2) the conversion instrument means the permanent share capital issued on its redemption.

31/10/2004

PRU 2.2.67

In PRU 2.2.65 R to PRU 2.2.69 R, the conversion ratio means the ratio of:

(1) the number of units of the conversion instrument that the firm must issue to satisfy its redemption obligation (so far as it is to be satisfied by the issue of conversion instruments) in respect of one unit of the original capital item; to
(2) one unit of the original capital item.

31/10/2004

PRU 2.2.68

In PRU 2.2.65 R, the conversion ratio as at the date of issue of the original capital item is calculated as if the original capital item were redeemable at that time.

31/10/2004

PRU 2.2.69

If the conversion instruments or the original capital item are subdivided or consolidated or subject to any other occurrence that would otherwise result in like not being compared with like, the conversion ratio calculation in PRU 2.2.65 R must be adjusted accordingly.

31/12/2004

Requirement to have sufficient unissued stock

PRU 2.2.70

(1) This rule applies to a potential tier one instrument of a firm where either:

(a) the redemption proceeds; or
(b) any coupon on that capital item;

can be satisfied by the issue of another tier one instrument.
(2) A firm may only include an item of capital to which this rule applies in its tier one capital resources if the firm has authorised and unissued tier one instruments of the kind in question (and the authority to issue them):

(a) that are sufficient to satisfy all such payments then due; and
(b) are of such amount as is prudent in respect of such payments that could become due in the future.

31/10/2004

Notifying the FSA of the issue and redemption of tier one instruments

PRU 2.2.71

A firm must not include any perpetual non-cumulative preference shares or innovative tier one instruments in its tier one capital resources for the purpose of PRU 2.2 unless it has notified the FSA of its intention at least one month before it first includes them.

31/10/2004

PRU 2.2.72

A firm must not redeem any tier one instrument that it has included in its tier one capital resources for the purpose of PRU 2.2 unless it has notified the FSA of its intention at least one month before it does so.

31/12/2004

Non standard capital instruments

PRU 2.2.73

There may be examples of capital instruments that, although based on a standard form, contain structural features that make the rules in PRU 2.2 difficult to apply. In such circumstances, a firm may seek individual guidance on the application of those rules to the capital instrument in question. See SUP 9 for the process to be followed when seeking individual guidance.

31/10/2004

Step-ups

PRU 2.2.74

In relation to a tier one instrument, a step-up means any change in the coupon rate on that instrument that results in an increase in the amount payable at any time, including a change already provided in the original terms governing those payments. A step-up:

(1) includes (in the case of a fixed rate) an increase in that coupon rate;
(2) includes (in the case of a floating rate calculated by adding a fixed amount to a fluctuating amount) an increase in that fixed amount;
(3) includes (in the case of a floating rate) a change in the identity of the benchmark by reference to which the fluctuating element of the coupon is calculated that results in an increase in the absolute amount of the coupon;
(4) does not include (in the case of a floating rate) an increase in the absolute amount of the coupon caused by fluctuations in the fluctuating figure by reference to which the absolute amount of the coupon floats.

31/10/2004

PRU 2.2.75

Where a rule in PRU 2.2 says that a particular treatment applies to an item of capital that is subject to a step-up of a specified amount, the question of whether that rule is satisfied must be judged by reference to the cumulative amount of all step-ups since the issue of that item of capital rather than just by reference to a particular step-up.

31/10/2004

Profit and loss account and other reserves

PRU 2.2.76

Negative amounts, including any interim net losses, must be deducted from profit and loss account and other reserves.

31/12/2005
Past version of PRU 2.2.76 before 31/12/2005

PRU 2.2.77

Dividends must be deducted from reserves as soon as they are declared.

31/10/2004

Valuation differences

PRU 2.2.78

Valuation differences are all differences between the valuation of assets and liabilities as valued in PRU and the valuation that the firm uses for its external financial reporting purposes, except valuation differences which are dealt with elsewhere in PRU 2.2.14 R. The sum of these valuation differences must either be added to (if positive) or deducted from (if negative) a firm's capital resources in accordance with PRU 2.2.14 R.

31/10/2004

PRU 2.2.79

Additions to and deductions from capital resources will arise from the application of asset and liability valuation and admissibility rules (see PRU 1.3, PRU 2.2.86 R and PRU 2 Annex 1R). Downward adjustments include discounting of technical provisions for general insurance business (which is optional for financial reporting but not permitted for regulatory valuation - see PRU 2.2.80 R to PRU 2.2.81 R) and derecognition of any defined benefit asset in respect of a defined benefit occupational pension scheme (see PRU 1.3.5B R). Details of valuation differences relating to technical provisions and liability adjustments for long-term insurance business are set out in PRU 7.3. In particular, contingent loans or other arrangements which are not valued as a liability under PRU 7.3.79R (2) result in a positive valuation difference.

21/04/2005
Past version of PRU 2.2.79 before 21/04/2005

PRU 2.2.80

PRU 2.2.81 R applies to a firm that carries on general insurance business, except a pure reinsurer, and which discounts or reduces its technical provisions for claims outstanding.

21/04/2005
Past version of PRU 2.2.80 before 21/04/2005

PRU 2.2.81

A firm of a kind referred to in PRU 2.2.80 R must deduct from its capital resources the difference between the undiscounted technical provisions or technical provisions before deductions and the discounted technical provisions or technical provisions after deductions. This adjustment must be made for all general insurance business classes, except for risks listed under classes 1 and 2. For classes other than 1 and 2, no adjustment needs to be made in respect of the discounting of annuities included in technical provisions. For classes 1 and 2 (other than annuities), if the expected average interval between the settlement date of the claims being discounted and the accounting date is not at least four years, the firm must deduct:

(1) the difference between the undiscounted technical provisions and the discounted technical provisions; or
(2) where it can identify a subset of claims such that the expected average interval between the settlement date of the claims and the accounting date is at least four years, the difference between the undiscounted technical provisions and the discounted technical provisions for the other claims.

21/04/2005
Past version of PRU 2.2.81 before 21/04/2005

Fund for future appropriations

PRU 2.2.81A

The fund for future appropriations means the fund of the same name required by the insurance accounts rules, comprising all funds the allocation of which either to policyholders or to shareholders has not been determined by the end of the financial year, or the balance sheet items under international accounting standards which in aggregate represent as nearly as possible that fund.

31/12/2005

Externally verified interim net profits

PRU 2.2.82

Externally verified interim net profits are interim profits verified by a firm's external auditors after deduction of tax, declared dividends and other appropriations.

31/10/2004

PRU 2.2.83

The FSA may request a firm to provide it with a copy of the external auditor's opinion on whether the interim profits are fairly stated.

31/10/2004

Intangible assets

PRU 2.2.84

A firm must deduct from its tier one capital resources the value of intangible assets.

31/10/2004

PRU 2.2.85

Intangible assets include goodwill, capitalised development costs, brand names, trademarks and similar rights, and licences.

31/10/2004

Inadmissible assets

PRU 2.2.86

For the purposes of PRU 2.2.14 R, a firm must deduct from total capital resources the value of any asset which is not an admissible asset as listed in PRU 2 Annex 1 R, unless the asset is held to cover property-linked liabilities or index-linked liabilities under PRU 4.2.57 R or PRU 4.2.58 R.

31/12/2005
Past version of PRU 2.2.86 before 31/12/2005

PRU 2.2.87

PRU 2.2.86 R does not apply to intangible assets which must be deducted from tier one capital resources under PRU 2.2.84 R.

31/10/2004

PRU 2.2.88

The list of admissible assets has been drawn with the aim of excluding assets:

(1) for which a sufficiently objective and verifiable basis of valuation does not exist; or
(2) whose realisability cannot be relied upon with sufficient confidence; or
(3) whose nature presents an unacceptable custody risk; or
(4) the holding of which may give rise to significant liabilities or onerous duties.

31/10/2004

Adjustments for related undertakings

PRU 2.2.89

A firm must deduct from its capital resources the value of its investments in each of its related undertakings that is an ancillary services undertaking.

31/10/2004

PRU 2.2.90

In relation to each of its related undertakings that is a regulated related undertaking (other than an insurance undertaking) a firm must add to (if positive), at stage J in PRU 2.2.14 R, or deduct from (if negative), at stage L in PRU 2.2.14 R, its capital resources the value of its shares in that undertaking calculated in accordance with PRU 1.3.35 R.

31/10/2004

PRU 2.2.91

For the purposes of PRU 2.2.89 R, investments must be valued at their accounting book value in accordance with PRU 1.3.5 R.

31/10/2004

PRU 2.2.92

Related undertakings which are also insurance undertakings are not included in PRU 2.2.90 R because a firm that is a participating insurance undertaking is subject to the requirements of PRU 8.3.

31/10/2004

Additional requirements for a tier one or tier two instrument issued by a firm carrying on with-profits insurance business

PRU 2.2.93

A firm carrying on with-profits insurance business must, in addition to the other requirements in respect of capital resources elsewhere in PRU 2.2, meet the following conditions before a capital instrument can be included in the firm's capital resources:

(1) the firm must manage the with-profits fund so that discretionary benefits under a with-profits insurance contract are calculated and paid disregarding, insofar as is necessary for its customers to be treated fairly, any liability the firm may have to make payments under the capital instrument;
(2) the intention to manage the with-profits fund on the basis set out in PRU 2.2.93 R (1) must be disclosed in the firm's Principles and Practices of Financial Management; and
(3) no amounts, whether interest, principal, or other amounts, must be payable by the firm under the capital instrument if the firm's assets would then be insufficient to enable it to declare and pay under a with-profits insurance contract discretionary benefits that are consistent with the firm's obligations under Principle 6.

31/10/2004

PRU 2.2.94

The purpose of PRU 2.2.93 R is to achieve practical subordination of capital instruments if they are to qualify as capital resources to the liabilities a firm has to with-profits policyholders, including liabilities which arise from the regulatory duty to treat customers fairly in setting discretionary benefits. (Principle 6 (Customers' interests) requires a firm to pay due regard to the interests of its customers and treat them fairly.) It is not sufficient for a capital instrument to be subordinated to such liabilities only on winding up of the firm because such liabilities to policyholders may have been reduced by the inappropriate use of management discretion to enable funds to be applied in repaying subordinated capital instruments before winding up proceedings commence.

31/10/2004

PRU 2.2.95

PRU 2.2.93 R is an additional requirement to all other rules in PRU 2.2 concerning the eligibility of a capital instrument to count as a component of a firm's capital resources. Subordinated debt instruments will be the main type of capital instrument to which this rule is relevant, including both upper tier two (undated) and lower tier two (dated) subordinated debt instruments. Subordinated debt instruments which are issued by a related undertaking are not intended to be covered by this rule and may be included in group capital resources as appropriate if the other eligibility criteria are met.

31/10/2004

PRU 2.2.96

PRU 2.2.29 R (8) and PRU 2.2.108 R (10) contain provisions concerning the marketing of a capital instrument. In relation to a firm to which PRU 2.2.93 R applies, in order to comply with PRU 2.2.29 R (8) and PRU 2.2.108 R (10), it should draw to the attention of subscribers the risk that payments may be deferred or cancelled in order to operate the with-profits fund so as to give priority to the payment of discretionary benefits to with-profits policyholders.

31/10/2004

PRU 2.2.97

(1) Upper tier two instruments must meet the requirements of PRU 2.2.101 R (3) which goes beyond the requirement in PRU 2.2.93 R (3) since it requires a firm to have the option to defer payments in all circumstances, not just if necessary to treat customers fairly. However, for lower tier two instruments, PRU 2.2.93 R (3) represents an additional requirement since a failure to pay amounts of interest or principal on a due date must not constitute an event of default under PRU 2.2.108 R (2) for firms carrying on with-profits insurance business.
(2) For firms which are realistic basis life firms compliance with PRU 2.2.93 R (3) would usually be achieved if the capital instrument provides that no amounts will be payable under it unless the firm's capital resources exceed its capital resources requirement. However, such firms should ensure that the terms of the capital instrument refer to FSA capital resources requirements in force from time to time, including the current realistic reserving requirements and are not restricted to former minimum capital requirements based only on the Insurance Directives' required minimum margin of solvency. For firms which are not realistic basis life firms, compliance with PRU 2.2.93 R (3) will probably require specific reference to be made to treating customers fairly in the terms of the capital instrument.

31/10/2004

Tier two capital

PRU 2.2.98

Tier two capital resources is split into upper and lower tiers. A major distinction between upper and lower tier two capital is that only perpetual instruments may be included in upper tier two capital whereas dated instruments, such as fixed term preference shares and dated subordinated debt, are included in lower tier two capital.

31/12/2005
Past version of PRU 2.2.98 before 31/12/2005

PRU 2.2.99

Tier two capital instruments are capital instruments that combine the features of debt and equity in that they are structured like debt, but exhibit some of the loss absorption and funding flexibility features of equity.

31/10/2004

Upper tier two capital

PRU 2.2.100

Examples of capital instruments which may be eligible to count in upper tier two capital resources include the following:

(1) perpetual cumulative preference shares;
(2) perpetual subordinated debt; and
(3) other instruments that have the same economic characteristics as (1) or (2).

31/10/2004

PRU 2.2.101

A capital instrument must meet the following conditions before it can be included in a firm's upper tier two capital resources:

(1) it must meet the general conditions described in PRU 2.2.108 R;
(2) it must have no fixed maturity date;
(3) the contractual terms of the instrument must provide for the firm to have the option to defer any interest payment in cash on the debt;
(4) the contractual terms of the instrument must provide for the loss-absorption capacity of the debt and unpaid interest, whilst enabling the firm to continue its business; and
(5) the contractual terms of the instrument must not provide for the instrument to be redeemable or the debt to be repayable on notice from the holder.

31/12/2005
Past version of PRU 2.2.101 before 31/12/2005

PRU 2.2.101A

Where a capital instrument meets PRU 2.2.101 R, and notice of the redemption or repayment of that instrument has been given by the firm in accordance with PRU 2.2.116A R, the firm must no longer include that instrument in its tier two capital resources.

31/12/2005

PRU 2.2.102

A capital instrument does not meet PRU 2.2.101 R (4) unless it meets PRU 2.2.103 R and PRU 2.2.105 R.

31/10/2004

PRU 2.2.103

A capital instrument may only be included in upper tier two capital resources if a firm's obligations under the instrument either:

(1) do not constitute a liability (actual, contingent or prospective) under section 123(2) of the Insolvency Act 1986; or
(2) do constitute such a liability but the terms of the instrument are such that:

(a) any such liability is not relevant for the purposes of deciding whether:

(i) the firm is, or is likely to become, unable to pay its debts; or
(ii) its liabilities exceed its assets;

(b) a creditor (including but not limited to a holder of the instrument) is not able to petition for the winding up or administration of the firm on the grounds that the firm is or may become unable to pay any such liability; and
(c) the firm is not obliged to take into account such a liability for the purposes of deciding whether or not the firm is, or may become, insolvent for the purposes of section 214 of the Insolvency Act 1986 (wrongful trading).

31/10/2004

PRU 2.2.104

The effect of PRU 2.2.103 R is that if an upper tier two instrument does constitute a liability, this should only be the case when the firm is able to pay that liability but chooses not to do so. As upper tier two capital resources must be undated, this will generally only be relevant on a solvent winding up of the firm.

31/10/2004

PRU 2.2.105

A firm wishing to issue an upper tier two instrument other than a perpetual preference share must obtain a properly reasoned legal opinion from Queen's Counsel or, where the opinion relates to the law of a jurisdiction outside the United Kingdom, from a lawyer in that jurisdiction of equivalent status, confirming that the criteria in PRU 2.2.101 R (4) are met.

31/12/2005
Past version of PRU 2.2.105 before 31/12/2005

PRU 2.2.106

For the purpose of PRU 2.2.103 R (2)(b) above, the holder should agree that the firm has no liability (including any contingent or prospective liability) to pay any amount to the extent to which that liability would cause the firm to become insolvent if it made the payment or to the extent that its liabilities exceed its assets or would do if the payment were made. The terms of the capital instrument should be such that the directors can continue to trade in the best interests of the senior creditors even if this prejudices the interests of the holders of the instrument.

31/10/2004

General conditions for eligibility as tier two capital

PRU 2.2.108

A capital instrument must not form part of the tier two capital resources of a firm unless it meets the following conditions:

(1) the claims of the creditors must rank behind those of all unsubordinated creditors;
(2) the only events of default must be non-payment of any amount falling due under the terms of the capital instrument or the winding-up of the firm;
(3) the remedies available to the subordinated creditor in the event of non-payment or other breach of the written agreement or instrument must be limited to petitioning for the winding-up of the firm or proving for the debt and claiming in the liquidation of the firm;
(4) any events of default and any remedy described in (3) must not prejudice the matters in (1) and (2);
(5) in addition to the requirement about repayment in (1), the debt must not become due and payable before its stated final maturity date (if any) except on an event of default complying with (2) or as permitted by PRU 2.2.116A R or PRU 2.2.123A R;
(6) the debt agreement or terms of the capital instrument are governed by the law of England and Wales, or of Scotland or of Northern Ireland;
(7) to the fullest extent permitted under the laws of the relevant jurisdictions, creditors must waive their right to set off amounts they owe the firm against subordinated amounts included in the firm's capital resources owed to them by the firm;
(8) the terms of the capital instrument must be set out in a written agreement that contains terms that provide for the conditions set out in (1) to (7);
(9) the debt must be unsecured and fully paid up;
(10) the description of its characteristics used in its marketing is consistent with the characteristics required to satisfy (1) to (9) and, where it applies, PRU 2.2.93 R; and
(11) the firm has obtained a properly reasoned external legal opinion stating that the requirements in (1) to (10) have been met.

31/12/2005
Past version of PRU 2.2.108 before 31/12/2005

PRU 2.2.109

For the purposes of PRU 2.2.108 R (5) the debt agreement or terms of the instrument should not contain any clause which might require early repayment of the debt (e.g. cross default clauses, negative pledges and restrictive covenants). A cross default clause is a clause which says that the loan goes into default if any of the borrower's other loans go into default. It is intended to prevent one creditor being repaid before other creditors, e.g. obtaining full repayment through the courts. A negative pledge is a clause which puts the loan into default if the borrower gives any further charge over its assets. A restrictive covenant is a term of contract that directly, or indirectly, could lead to early repayment of the debt. Some covenants, e.g. relating to the provision of management information or ownership restrictions, are likely to comply with PRU 2.2.108 R (5) as long as monetary redress is ruled out, or any payments are covered by the subordination and limitation of remedies clauses (that is, if damages are unpaid, the only remedy is to petition for a winding up).

31/10/2004

PRU 2.2.110

The purpose of PRU 2.2.108 R (7) is to ensure that all of the firm's assets are available to customers ahead of subordinated creditors. The waiver should apply both before and during liquidation.

31/10/2004

PRU 2.2.111

PRU 2.2.108 R (6) does not apply if the firm has obtained a properly reasoned external legal opinion confirming that the same degree of subordination has been achieved under the law that governs the debt and the agreement as that which would have been achieved under the laws of England and Wales, Scotland, or Northern Ireland.

31/10/2004

PRU 2.2.112

An item of capital does not comply with PRU 2.2.108 R (10) if it is marketed as a capital instrument that would only qualify for a lower level of capital or on the basis that investing in it is like investing in a lower tier capital instrument. For example, an undated capital instrument should not be marketed as a dated capital instrument if the terms of the capital instrument include an option by the issuer to redeem the capital instrument at a specified date in the future.

31/10/2004

PRU 2.2.113

(1) An item of capital does not comply with PRU 2.2.101 R or PRU 2.2.108 R if the issue of that item of capital by the firm is connected with one or more other transactions which, when taken together with the issue of that item, could produce the effect described in (2).
(2) The effect referred to in (1) is a reduction in the economic benefit intended to be conferred on the firm by the issue of the item of capital which means that the item of capital no longer displays all of the characteristics set out in PRU 2.2.101 R or PRU 2.2.108 R.

31/10/2004

PRU 2.2.114

For the purposes of PRU 2.2.113 R, examples of connected transactions might include guarantees or any other side agreement provided to the holders of the capital instrument by the firm or a connected party or a related transaction designed, for example, to enhance their security or to achieve a tax benefit, but which may compromise the loss absorption capacity or permanence of the original capital item.

31/10/2004

PRU 2.2.115

The FSA is more concerned that the subordination provisions listed in PRU 2.2.108 R should be effective than that they should follow a particular form. The FSA does not, therefore, prescribe that the loan agreement should be drawn up in a standard form.

31/12/2004

PRU 2.2.116

A firm must not amend the terms of the debt and the documents referred to in PRU 2.2.108 R (8) unless:

(1) at least one month before the amendment is due to take effect, the firm has given the FSA notice in writing of the proposed amendment and the FSA has not objected; and
(2) that notice includes confirmation that the legal opinions referred to in PRU 2.2.108 R (11) and, if applicable, PRU 2.2.105 R and PRU 2.2.111 R, continue in full force and effect in relation to the terms of the debt and documents, notwithstanding any proposed amendment.

31/10/2004

PRU 2.2.116A

A tier two instrument may be redeemable at the option of the firm, but any contractual term of the instrument providing for the firm to have the right to exercise such an option on a specified date must not provide for that right to be exercisable earlier than the fifth anniversary of the date of issue of the instrument.

31/12/2005

PRU 2.2.117

A firm must notify the FSA of its intention to repay a tier two instrument at least six months before the date of the proposed repayment (unless the firm intends to repay an instrument on its contractual repayment date) providing details of how it will meet its capital resources requirement after such repayment.

31/10/2004

Step-ups

PRU 2.2.118

In relation to a tier two instrument, a step-up in a coupon rate means:

(1) (in the case of a fixed rate) an increase in that rate;
(2) (in any other case) any change in the way that the interest or other payment is calculated that may result in an increase in the amount payable at any time, including a change already provided in the original terms governing those payments.

31/10/2004

PRU 2.2.119

Where a tier two instrument is subject to one or more step-ups, the first date that a step-up can take effect must be treated, for the purposes of this section, as the instrument's final maturity date if its actual maturity date occurs after that, unless the effect of the step-up or step-ups as calculated as at the date of issue of the instrument is to increase the coupon rate at which payments are to be made by no more than:

(1) 50 basis points in the first ten years of the life of the debt; or
(2) 100 basis points over the whole life of the debt.

31/12/2005
Past version of PRU 2.2.119 before 31/12/2005

PRU 2.2.120

A firm may not include in its tier two capital resources a capital instrument the terms of which provide for a step-up in the first five years after issue.

31/10/2004

PRU 2.2.121

Where a step-up arises through a change from paying a coupon on a debt instrument to paying a dividend on a share issued in settlement of the coupon, any net cost to the firm arising from the different tax treatment of the dividend compared to the tax treatment of interest may be ignored for the purpose of assessing the effect of the step-up.

31/12/2005
Past version of PRU 2.2.121 before 31/12/2005

PRU 2.2.122

Debt instruments containing embedded options, e.g. issues containing options for the interest rate after the step-up to be at a margin over the higher of two (or more) reference rates, or for the interest rate in the previous period to act as a floor, may affect the funding costs of the borrower and imply a step-up. In such circumstances, a firm may wish to seek individual guidance on the application of the rules relating to step-ups to the capital instrument in question. See SUP 9 for the process to be followed when seeking individual guidance.

31/10/2004

Other conditions for eligibility as lower tier two capital

PRU 2.2.122A

Capital instruments that meet the general conditions described in PRU 2.2.108 R, including perpetual capital instruments that do not meet one or more of the conditions in PRU 2.2.101 R (3), (4) and (5), may be included in lower tier two capital resources.

31/12/2005

PRU 2.2.123

A capital instrument may be included in lower tier two capital resources only if it has an original maturity of at least five years or it has no fixed maturity date.

31/12/2005
Past version of PRU 2.2.123 before 31/12/2005

PRU 2.2.123A

A lower tier two instrument may include a contractual term providing for the instrument to be redeemable on notice from the holder, but the period of notice of redemption or repayment required to be given by the holder must not be less than five years.

31/12/2005

PRU 2.2.124

For the purposes of calculating the amount of a lower tier two instrument which may be included in a firm's capital resources:

(1) in the case of an instrument with a fixed maturity date, in the final five years to maturity; and
(2) in the case of an instrument with or without a fixed maturity date but where five or more years' notice of redemption or repayment has been given, in the final five years to the date of redemption or repayment;

the principal amount must be amortised on a straight line basis.

31/12/2005
Past version of PRU 2.2.124 before 31/12/2005

Unpaid share capital or initial funds and calls for supplementary contributions

PRU 2.2.126

Unpaid share capital or, in the case of a mutual, unpaid initial funds and calls for supplementary contributions are excluded from the capital resources of a firm except to the extent allowed in a waiver under section 148 of the Act.

31/10/2004

PRU 2.2.127

Subject to a waiver, under the Insurance Directives a maximum of one half of unpaid share capital or, in the case of a mutual, one half of the unpaid initial fund may be included in a firm's capital resources, once the paid-up part amounts to 25% of that share capital or fund, up to 50% of total capital resources.

31/12/2004

PRU 2.2.128

In the case of a mutual carrying on general insurance business and subject to a waiver, calls for supplementary contributions within the financial year may only be included in a firm's capital resources up to a maximum of 50% of the difference between the maximum contributions and the contributions actually called in, subject to a limit of 50% of total capital resources. In the case of a mutual carrying on long-term insurance business, the Consolidated Life Directive does not permit calls for supplementary contributions to be included in firm's capital resources.

31/10/2004

PRU 2.3

Individual Capital Assessment

01/10/2005

Application

PRU 2.3.1

PRU 2.3 applies to an insurer unless it is:

(1) a non-directive friendly society; or
(2) a Swiss general insurer; or
(3) an EEA-deposit insurer; or
(4) an incoming EEA firm; or
(5) an incoming Treaty firm.

31/12/2004

Purpose

PRU 2.3.2

Principle 4 requires a firm to maintain adequate financial resources. PRU 2 sets out provisions that deal specifically with the adequacy of that part of a firm's financial resources that consists of capital resources. The adequacy of a firm's capital resources needs to be assessed both by the firm and the FSA. In PRU 2.1, the FSA sets minimum capital resources requirements for firms. It also reviews a firm's own assessment of its capital needs, and the processes and systems by which that assessment is made, in order to see if the minimum capital resources requirements are appropriate. PRU 1.2 contains rules requiring a firm to identify and assess risks to its being able to meet its liabilities as they fall due, to assess how it intends to deal with those risks and to quantify the financial resources it considers necessary to mitigate those risks. To meet these requirements, a firm should consider the extent to which capital is an appropriate mitigant for the risks identified and assess the amount and quality of capital required. In accordance with PRU 1.2.37 R, these assessments must be documented so that they can be easily reviewed by the FSA as part of the FSA's assessment of the adequacy of the firm's capital resources.

31/12/2004

PRU 2.3.3

This section (PRU 2.3) sets out guidance on how firms should assess the adequacy of their capital resources, both to comply with the rules in PRU 1.2 and to enable the FSA better to assess whether the minimum capital resources requirements in PRU 2.1 are appropriate. This section also requires firms carrying on general insurance business to calculate their ECR. 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 realistic basis life firms, the ECR forms part of the calculation of the firm's capital resources requirement (see PRU 2.1.15 R). The ECR for such firms requires the calculation of a with-profits insurance capital component (see PRU 7.4) that supplements the mathematical reserves so as to ensure that a firm holds adequate financial resources for the conduct of its with-profits insurance business. In the case of firms carrying on general insurance business and realistic basis life firms, the FSA will use the ECR as a benchmark for its consideration of the appropriateness of the firm's own capital assessment. For firms where an ECR is not calculated the MCR will provide a benchmark for the firm's own capital assessment. For firms generally, the more thorough, objective and prudent a firm's capital assessment is and can be demonstrated as being, the more reliance the FSA will be able to place on the results of that assessment. The FSA will consider the appropriateness of the firm's capital assessment to establish the level of capital resources the firm needs. This may result in the FSA's assessment of a firm's capital resources needs being lower or higher than would otherwise be the case.

31/12/2004

PRU 2.3.4

There are two main purposes of this section:

(1) to enable firms to understand the issues which the FSA would expect to see assessed and the systems and processes which the FSA would expect to see in operation for capital adequacy assessments by the firm to be regarded as thorough, objective and prudent; and
(2) to enable firms to understand the FSA's approach to assessing whether the minimum capital resources requirements of PRU 2.1 are appropriate and what action may be taken if the FSA concludes that those requirements are not appropriate to a firm's circumstances.

31/12/2004

Main requirements and guidance

PRU 2.3.5

In making an assessment of capital adequacy, the FSA requires firms to identify the major risks they face and, where capital is appropriate to mitigate those risks, to quantify how much (and what type) of capital is appropriate. To do this, the FSA expects firms to conduct stress tests and scenario analyses in respect of each risk. For each risk the firm will then be able to estimate a range of probable outcomes and hence capital required to absorb losses which might arise. A firm must document the results of each of the stress tests and scenario analyses undertaken and should also document, as part of the details of those tests and analyses, the key assumptions including the aggregation of the results.

31/12/2004

PRU 2.3.6

The assessment which a firm makes should be based upon its future business plans and projections. This is the main area where the firm's assessment may diverge from its prescribed capital resources requirement which, necessarily, is based upon historic data.

31/12/2004

PRU 2.3.7

In assessing the quality and the amount of capital resources projected to be available to meet its projected capital resources requirement, a firm should consider the timing of its liabilities to repay existing capital together with the prospects for raising new capital in the scenarios considered.

31/12/2004

PRU 2.3.8

The FSA may ask for the results of a firm's assessment to be provided to it together with a description of the processes by which the assessment has been made, the range of results from each stress test or scenario analysis performed and the main assumptions made. The FSA may also carry out a more detailed examination of the details of the firm's processes and calculations.

31/12/2004

PRU 2.3.9

Based upon this information and other information available to the FSA, the FSA will consider whether the capital resources requirement applicable to the firm is appropriate. Where relevant, the firm's ECR will be a key input to the FSA's assessment of the adequacy of the firm's capital resources.

31/12/2004

PRU 2.3.10

A firm carrying on general insurance business, other than a non-directive insurer, must calculate the amount of its ECR.

31/12/2004

PRU 2.3.11

A firm to which PRU 2.3.10 R applies must calculate its ECR in respect of its general insurance business as the sum of:

(1) the asset-related capital requirement; and
(2) the insurance-related capital requirement; less
(3) the firm's equalisation provisions.

31/12/2004

PRU 2.3.12

Details of the calculation of the asset-related capital requirement are set out in PRU 3.3.10 R to PRU 3.3.16 R. 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.

31/12/2004

PRU 2.3.13

Where the FSA considers that a firm will not comply with PRU 1.2.22 R (adequate financial resources, including capital resources) by holding the capital resources required by PRU 2.1, the FSA may give the firm individual guidance advising it of the amount and quality of capital resources which the FSA considers it needs to hold in order to meet that rule.

31/12/2004

PRU 2.3.14

The individual guidance will be given taking into consideration capital resources consistent with a 99.5% confidence level over a one year timeframe or, if appropriate to the firm's business, an equivalent lower confidence level over a longer timeframe. Firms should therefore prepare an individual capital assessment on the same basis. Throughout whatever timeframe is adopted by firms, firms should ensure that their projected assets are, and will continue to be, sufficient, to enable their projected liabilities to be paid, and it would be reasonable for firms to test that this is the case at the end of each year of the timeframe. Firms may also wish to make estimates of capital adequacy using other assumptions for their own internal purposes and are free to do so if they so choose.

31/12/2004

PRU 2.3.15

If a firm considers that the individual guidance is inappropriate to its circumstances, then the firm should inform the FSA that it does not intend to follow that guidance. Informing the FSA of such an intention would be expected if a firm is to comply with Principle 11 (relations with regulators).

31/12/2004

PRU 2.3.16

The FSA expects most disagreements about the adequacy of capital will be resolved through further analysis and discussion. The FSA may consider the use of its powers under section 166 of the Act (Reports by skilled persons) to assist in such circumstances. If the FSA and the firm still do not agree on an adequate level of capital, then the FSA may consider using its powers under section 45 of the Act to, on its own initiative, vary a firm's Part IV permission so as to require it to hold capital in accordance with the FSA's view of the capital necessary to comply with PRU 1.2.22 R. SUP 7 provides further information about the FSA's powers under section 45.

31/12/2004

PRU 2.3.17

Where a firm or the FSA considers that the capital resources requirements of PRU 2.1 require the holding of more capital than is needed for the firm to comply with PRU 1.2.22 R then the firm may apply to the FSA for a waiver of the requirements in PRU 2.1 under section 148 of the Act. This section sets out the factors which the FSA will consider in deciding whether to grant such a waiver request, and if so, the terms and extent of any modification to the rules in PRU 2.1. In addition to the statutory tests under section 148, these will include the thoroughness, objectivity, and prudence of a firm's own capital assessment and the extent to which the guidance in this section has been followed. The FSA will not grant a waiver that would cause a breach of the minimum capital requirements under the Insurance Directives.

31/12/2004

Stress and scenario requirement

PRU 2.3.18

PRU 1.2.35 R requires a firm to carry out stress tests and scenario analyses for each of the sources of risk identified in accordance with PRU 1.2.31 R. Using each of the risk categories set out in PRU 1.2.31 R, PRU 2.3.19 G to PRU 2.3.34 G set out the factors that a firm should consider. PRU 2 Ann 3 G provides a practical illustration of how a small firm carrying on general insurance business might undertake this analysis.

31/12/2004

Factors to consider when assessing credit risk

PRU 2.3.19

Credit risk refers to the risk of loss if another party fails to perform its obligations or fails to perform them in a timely fashion.

31/12/2004

PRU 2.3.20

In assessing potential credit risk events that may affect the firm's solvency, a firm should allow for:

(1) the financial effect of non-payment of reinsurance, considering the likelihood both of non-payment of outstanding claims and for the fact that reinsurance cover purchased for underwritten risks may not be effective (that is, offsetting potential liabilities); and
(2) the financial effect of non-payment of premium debtors such as intermediaries and policyholders.

31/12/2004

PRU 2.3.21

Some further areas to consider in developing the credit risk stress tests and scenario analyses might include:

(1) the adequacy of the reinsurance programme and whether it is appropriate for the risks selected by the firm and adequately takes account of the underwriting and business plans of the firm generally;
(2) the collapse of a reinsurer or several reinsurers on the firm's reinsurance programme and the subsequent impact this may have on the firm's outstanding reinsurance recoveries and IBNR recoveries;
(3) a deterioration in the creditworthiness of the firm's reinsurers, intermediaries or other counterparties;
(4) the degree of credit concentration. For example, the degree to which a firm is exposed to a single counterparty or group;
(5) the degree of concentration of exposure to reinsurers of particular rating grades;
(6) the prospect of reinsurance rates increasing substantially or reinsurance being unavailable;
(7) any existing or possible future disputes relating to reinsurance contracts on a pessimistic basis and the extent that they are not already reflected in the value attributed to the reinsurances;
(8) greater losses from bad debts than anticipated;
(9) deterioration in the extent and quality of collateral; and
(10) guarantees given by the insurer of the performance of others, whether under contracts of insurance or otherwise.

31/12/2004

Factors to consider when assessing market risk

PRU 2.3.22

Market risk includes the risks that arise from fluctuations in values of, or income from, assets or in interest or exchange rates.

31/12/2004

PRU 2.3.23

In assessing potential market risk events that may affect the firm's solvency, a firm should allow for:

(1) reduced market values of investments;
(2) variation in interest rates and the effect on the market value of investments;
(3) a lower level of investment income than planned; and
(4) the possibility of counterparty defaults.

31/12/2004

PRU 2.3.24

Some further areas to consider in developing the market risk scenario might include:

(1) the possibility of a severe economic or market downturn or upturn leading to adverse interest rate movements affecting the firm's investment position;
(2) unanticipated losses and defaults of issuers;
(3) price shifts in asset classes, and their impact on the entire portfolio;
(4) inadequate valuation of assets;
(5) the direct impact on the portfolio of currency devaluation, as well as the effect on related markets and currencies;
(6) extent of any mismatch of assets and liabilities, including reinvestment risk;
(7) the impact on the portfolio value of a dramatic change in the spread between a market index of interest rates and the risk-free interest rates; and
(8) the extent to which market moves could have non-linear effects on values, such as derivatives.

31/12/2004

Factors to consider when assessing liquidity risk

PRU 2.3.25

In accordance with PRU 1.2.31 R a firm should consider the major sources of risk, including liquidity risks, and assess its response should each risk materialise.

31/12/2004

PRU 2.3.26

PRU 5.1 (liquidity risk systems and controls) contains evidential provisions and guidance on how firms should meet PRU 1.2.22 R for liquidity purposes.

(1) PRU 5.1.61 E states that a scenario analysis in relation to liquidity risk required under PRU 1.2.35 R should include a cash-flow projection for each scenario tested, based on reasonable estimates of the impact of that scenario on the firm's funding needs and sources.
(2) PRU 5.1.86 E states that a firm should have a contingency funding plan for taking action to ensure, so far as it can, that in each of the scenarios tested under PRU 1.2.35R (2), it would still have sufficient liquid financial resources to meet liabilities as they fall due.

31/12/2004

PRU 2.3.27

When assessing liquidity risk, the firm should consider the extent of mismatch between assets and liabilities and the amount of assets held in highly liquid, marketable forms should unexpected cashflows lead to a liquidity problem. The price concession of liquidating assets is a prime concern when assessing such liquidity risk and should be built into any assessment of capital adequacy.

31/12/2004

PRU 2.3.28

Some further areas to consider in developing the liquidity risk scenario might include:

(1) any mismatching between expected asset and liability cash flows;
(2) the inability to sell assets quickly;
(3) the extent to which the firm's assets have been pledged;
(4) the cash-flow positions generally of the firm and its ability to withstand sharp, unexpected outflows of funds via claims, or an unexpected drop in the inflow of premiums; and
(5) the possible need to reduce large asset positions at different levels of market liquidity, and the related potential costs and timing constraints.

31/12/2004

Factors to consider when assessing operational risk

PRU 2.3.29

Operational risk refers to the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.

31/12/2004

PRU 2.3.30

A firm may wish to refer to SYSC 3A and PRU 6.1 when carrying out its operational risk assessment.

31/12/2004

PRU 2.3.31

Examples of some issues that a firm might want to consider include:

(1) the likelihood of fraudulent activity occurring that may impact upon the financial or operational aspects of the firm;
(2) the obligation a firm may have to fund a pension scheme for its employees;
(3) the technological risks that the firm may be exposed to regarding its operations. For example, risks relating to both the hardware systems and the software utilised to run those systems;
(4) the reputational risks to which the firm is exposed. For example, the impact on the firm if the firm's brand is damaged resulting in a loss of policyholders from the underwriting portfolio;
(5) the marketing and distribution risks that the firm may be exposed to. For example, the dependency on intermediary business or a firm's own sales force;
(6) the impact of legal risks. For example a non-insurance related legal action being pursued against the firm;
(7) the management of employees - for instance staff strikes, where dissatisfied staff may withdraw goodwill and may indulge in fraud or acts giving rise to reputational loss;
(8) the resourcing of key functions such as the risk management function by staff in appropriate numbers and with an appropriate mix of skills such as underwriting, claims handling, accounting, actuarial and legal expertise.

31/12/2004

PRU 2.3.32

A firm may consider that investigation of operational weaknesses and corrective action is a better response than holding capital and may consider that a certain degree of operational risk is within its pre-defined risk tolerance. However, until the firm corrects any identified deficiencies a firm should consider capital as a (interim) response to the risk.

31/12/2004

Factors to consider when assessing insurance risk

PRU 2.3.33

As a result of the differences between the nature of general and long-term insurance business, some aspects of the risk assessment vary depending on the type of business written. In assessing potential insurance risk events that may affect the firm's solvency, general and long-term insurance business firms should:

(1) analyse the potential for catastrophic losses, including both risk and event losses, the cost of reinstatement premiums and any possible reinsurance exhaustion; and
(2) determine the likelihood of any other feature of insurance risk that may lead to a variation in projected outcomes.
(3) Firms carrying on general insurance business should in addition:

(a) analyse the potential for claims reserves to deteriorate beyond the current reserving level; and
(b) determine the effect of loss ratios being higher than planned by analysing historic loss ratio experience and volatility.

(4) Firms carrying on long-term insurance business should in addition:

(a) analyse the potential for mathematical reserves subsequently to prove inadequate compared with the current reserving level; and
(b) determine the effect of claims experience being more costly than planned by analysing historic claims experience, volatility and trends in experience.

31/12/2004

PRU 2.3.34

Some further areas to consider in developing the insurance risk scenario might include:

(1) For underwriting risks, general insurance business and long-term insurance business firms:

(a) the adequacy of the firm's pricing. For example, the firm should be able to satisfy itself that it can charge adequate rates, taking into account the business and the risk profile of different products, the business environment (e.g. premium cycle-non-life) and its own internal profit targets;
(b) the uncertainty of claims experience;
(c) the dependence on intermediaries for a disproportionate share of the insurer's premium income; the effects of a high level of uncertainty in pricing in new or emerging underwriting markets due to a lack of information needed to enable the insurer to make a proper assessment of the price of the risk; the geographical mix of the portfolio or whether any geographical or jurisdictional concentrations exist;
(d) the appropriateness of policy wordings;
(e) the risk of mis-selling, for example, the number of complaints or disputed claims; and
(f) the tolerance for expense reserve variations or variations in expenses (including indirect costs).

(2) For firms carrying on general insurance business, in addition:

(a) the length of tail of the claims development and latent claims; and
(b) the effects of rapid growth or decline in the volume of the underwriting portfolio.

(3) For firms carrying on long-term insurance business, in addition:

(a) the uncertainty of future investment returns;
(b) the effects of rapid growth or decline in the volume and nature of new business written; and
(c) the ability of firms to adjust premium rates or charges for some products.

(4) For reserving and claims risks, both general insurance business and long term insurance business firms:

(a) the frequency and size of large claims;
(b) possible outcomes relating to any disputed claims, particularly where the outcome is subject to legal proceedings;
(c) the ability of the firm to withstand catastrophic events, increases in unexpected exposures, latent claims or aggregation of claims;
(d) the possible exhaustion of reinsurance arrangements, both on a per risk and per event basis;
(e) social changes regarding an increase in the propensity to claim and to sue; and
(f) other social, economic and technological changes.

(5) For firms carrying on general insurance business:

(a) the adequacy and uncertainty of the technical claims provisions, such as outstanding claims, IBNR and claims handling expense reserves;
(b) the adequacy of other underwriting provisions, such as the provisions for unearned premium and unexpired risk reserves;
(c) the appropriateness of catastrophe models and underlying assumptions used, such as possible maximum loss (PML) factors used;
(d) unanticipated legal judgements and legal change with retrospective effect specifically with regard to the claims reserves; and
(e) the effects of inflation.

(6) For firms carrying on long-term insurance business:

(a) the adequacy and sensitivity of the mathematical reserves to variations in future experience, including:

(i) the risk that investment returns differ from those assumed in the reserving assumptions;
(ii) the risk of variations in mortality, morbidity and persistency experience and in the exercise of options under contracts;
(iii) the rates of taxation applied, in particular where there is uncertainty over the tax treatment; and

(b) unanticipated legal judgements and legal change with retrospective effect specifically with regard to the impact on mathematical reserves.

31/12/2004

Other assessments of the adequacy of capital resources

PRU 2.3.35

Firms must assess the adequacy of their financial resources and this will entail an assessment of both capital resources and liquidity resources. The stress tests and scenario analyses which a firm must carry out will assist with both assessments. However, firms may also find it helpful to approach their assessment of capital in another way.

31/12/2004

PRU 2.3.36

Firms may also wish to carry out an additional assessment to inform their view as to whether their capital resources are adequate. The additional assessment is to consider the extent to which the capital resources requirement (CRR) produces adequate capital for a firm's particular circumstances. In considering this, firms that are required to calculate an Enhanced Capital Requirement (ECR) may wish to note that the ECR as calculated is based upon the assumptions that a firm's business is well diversified, well managed with assets matching its liabilities and good controls, and stable with no large, unusual, or high risk transactions. Firms may find it helpful to assess the extent to which their actual business differs from these assumptions and therefore what adjustments it might be reasonable to make to the CRR or ECR to arrive at an adequate level of capital resources.

31/12/2004

PRU 2.3.37

Firms may find it helpful for their own assessment process if they also consider divergences from the assumptions described in PRU 2.3.36 G under the headings set out below. These are the areas which the FSA considers when forming its view of the adequacy of a firm's capital resources.
Business risk factors:

(1) market risk;
(2) securitisation risk;
(3) residual risk;
(4) concentration risk;
(5) high impact, low probability events; and
(6) cyclicality and capital planning.

Control risk factors:

(1) systems and controls.

31/12/2004

PRU 2.3.38

Market risk: a firm should assess its exposure to those elements of market risk that are not captured by the CRR. In doing so, firms may wish to use stress tests to determine the impact on their balance sheets of an appropriate move in market conditions. The results of this test should then be used by the firm to determine its market risk.

31/12/2004

PRU 2.3.39

Securitisation risk: a firm should assess its exposure to risks transferred through the securitisation of assets should those transfers fail for whatever reason. For instance, firms may contemplate two broad types of securitisation: 'embedded value securitisation' - the transfer of the value emerging from an existing block of business to bondholders; and 'risk transfer securitisation' - the purchase of protection against catastrophic risks to the insurer through the issuance of bonds whose repayment is contingent upon the non-occurrence of such risks. In either case, firms should consider the effect on their financial position of a failure of such complex arrangements to operate as anticipated or the values and risks transferred not emerging as expected.

31/12/2004

PRU 2.3.40

Residual risk: a firm should assess its exposure to the residual risks that may result from the partial performance or failure of risk mitigation techniques for reasons that are unconnected with their intrinsic value. This could result from (for example): ineffective documentation, a delay in payment or the inability to realise payment from a guarantor in a timely manner. Given that residual risks can always be present, firms should assess the appropriateness of their capital resources requirement against their assumptions for the risk mitigation measures that they may have in place.

31/12/2004

PRU 2.3.41

Concentration risk: a firm should assess and monitor its exposure to: sector, geographic, liability and asset concentrations, as well as granularity. The FSA considers that concentrations in these areas increase the firm's credit risk and where the firm identifies concentrations then they should consider the adequacy of the capital resources requirement. For instance, firms should monitor concentrations of exposure to particular reinsurers and ensure that they are aware of the implications of several of their reinsurers failing at the same time.

31/12/2004

PRU 2.3.42

High impact, low probability events: firms should consider stress tests and scenario analyses which are realistic - that is not too remote a possibility. However, should a firm decide to enter into a high impact, low probability transaction, the firm should satisfy itself that it has sufficient financial resources to meet its resulting financial obligation in the event the single risk materialises. For instance, a firm should not accept individual risks in circumstances where, if that single risk materialised, the claim arising would exceed the financial resources available to the firm.

31/12/2004

PRU 2.3.43

A firm should also consider the value of the financial obligation arising where the risks from a combination of high impact, low probability transactions that the firm has entered into materialise at the same time. A firm should ensure that in no circumstances would a combination of any consequent claims materially exceed the financial resources available to it.

31/12/2004

PRU 2.3.44

Cyclical and capital planning: a firm's capital resources requirement may vary as business cycles and economic conditions fluctuate over time. Firms should be aware that a deterioration in business or economic conditions could require them to raise capital or alternatively to contract their businesses at a time when market conditions are most unfavourable to raising capital. Such an effect is known as procyclicality.

31/12/2004

PRU 2.3.45

To reduce the impact of cyclical effects, firms should look to build-up capital levels through the course of an upturn in business and economic cycles to ensure that they have sufficient capital available to protect themselves against adverse conditions.

31/12/2004

PRU 2.3.46

To assess its expected capital requirements over the economic and business cycles, a firm may wish to project forward its financial position taking account of its business strategy and expected growth under a range of environmental assumptions. Projections over a three to five year period would be appropriate in most circumstances. Firms may then calculate their projected capital resources requirement and assess whether that requirement could be met from expected financial resources.

31/12/2004

PRU 2.3.47

Systems and controls: a firm may decide to hold additional capital resources to mitigate weaknesses in its overall control environment. Weaknesses might be indicated by the following:

(1) a failure by the firm to complete an assessment of its systems and controls in line with SYSC 3.1 (Systems and Controls) and PRU 1.4;
(2) a failure by the firm's senior management to approve its financial results; and
(3) a failure by the firm to consider an analysis of relevant internal and external information on its business and control environment.

31/12/2004

PRU 2.3.48

In considering any systems and control weaknesses and their effect on the adequacy of the capital resources requirement, a firm may wish to be able to demonstrate to the FSA that all the issues identified in SYSC 3.2 (Areas covered by systems and controls) have been considered; and that appropriate plans and procedures exist to deal adequately with adverse scenarios.

31/12/2004

Capital models

PRU 2.3.49

A firm may approach its assessment of adequate capital resources by developing a model for some or all of its business risks. Where such a model captures some of the risks identified in accordance with PRU 1.2.31 R then this will usually satisfy the requirement to perform stress tests in respect of those risks. However, the assumptions required to aggregate risks modelled and the confidence levels adopted should be considered by the firm's senior management. A firm should also consider whether any risks are not captured by the model and also the extent to which systems and control risks are not incorporated in the model.

31/12/2004

PRU 2.3.50

A firm should not expect the FSA to accept as adequate any particular model that it develops or that the results from the model are automatically reflected in any individual guidance given to the firm for the purpose of determining adequate capital resources. However, the FSA will take into account the results of any sound and prudent model when giving individual guidance or considering applications for a waiver under section 148 of the Act of the capital resources requirement in PRU 2.1. This section sets out the types of issues the FSA would consider before giving individual guidance or granting a waiver based on the results of a model.

31/12/2004

PRU 2.3.51

There is no prescribed modelling approach for how a firm develops its internal model. However, firms should be able to demonstrate:

(1) the extent of use of the internal capital model within the firm's capital management policy;
(2) that sound and appropriate risk-management techniques are employed and are embedded in the daily operations and financial resources requirements of the firm;
(3) that all material risks to which the firm is exposed have been adequately addressed by quantitative and qualitative means as appropriate;
(4) the confidence levels set and whether these are linked to the firm's corporate strategy;
(5) the time horizons set for the different types of business that the firm undertakes;
(6) the extent of historic data used and back testing carried out; and
(7) whether sufficient accuracy and validation in the internal capital model has been undertaken.

31/12/2004

Quantitative factors

PRU 2.3.52

The firm's model should be based on an appropriate probability of insolvency over an appropriate time period. A firm should be able to demonstrate the selected probability of insolvency and time horizon it has derived and explain why these are appropriate for its business.

31/12/2004

PRU 2.3.53

Good models will have as inputs (in addition to the specific examples given under the stress and scenario guidance):
For both firms carrying on general insurance business and long-term insurance business:

(1) assumed future investment returns. In particular, assumptions for future interest rates (to the extent that they impact on interest income on funds on deposit, price of and yield on fixed stock that may be purchased in future and interest income on variable interest rate assets), equity prices, dividend income, property prices, property rental income and inflation. The assumptions should take account of likely volatility and historic volatility in interest rates and asset prices;
(2) five-year predictions as to premium rates in each homogeneous category of business taking account of the effect of underwriting cycles;
(3) predictions of exposures written in each homogeneous category of business in the next five years;
(4) predictions of premium volume and expected growth under a five year business plan;
(5) expenses and commission;
(6) catastrophic events, aggregations of claims and claims affecting more than one class of business;
(7) inflation in terms of how it might affect future claims, non-settled claims that have occurred to date, future expenses, future reinsurance costs and future investment returns;
(8) reinsurance programmes in place, allowing for changing term conditions, reinstatements and loss experience features;
(9) estimates of non-recovery of reinsurance and other debtors taking account of the financial strength of each reinsurance or other counterparty; and
(10) foreign exchange movements.

For firms carrying on general insurance business in particular:

(11) frequency and severity of claims (including costs associated with claims such as professional fees) for each homogeneous category of business, allowing for any impact of future social, legal and inflationary effects (especially concerning price, earnings, medical and claims) on future claims costs;
(12) settlement patterns of claims and reinsurance recoveries for each homogeneous category of business (including occurred and future claims);
(13) unintended coverage of risks; and
(14) correlation between these risks.
For firms carrying on long-term insurance business in particular:
(15) projected claims experience for each homogeneous category of business allowing for trends in mortality/ morbidity experience;
(16) assumptions for future policyholder actions such as lapsing or surrendering a policy, ceasing to pay premiums or choosing to exercise an option under the contract; and
(17) for business where management has discretion over the level of benefits or charges, assumptions about management reactions to changes in economic conditions and consequent changes to the benefits or charges.

31/12/2004

PRU 2.3.54

The FSA places credence in approaches to financial models to aid the assessment of capital adequacy which involve the production of a Dynamic Financial Analysis ("DFA") model. These models transform each element in the financial projection into a statistical distribution with a range of possible outcomes, and are therefore stochastic. They would generally incorporate a suitable economic model integrated into the DFA model and linked into the generation of insurance related assumptions. The model would, as far as possible, cover all risks and all areas of business. The future time period over which projections are made should be determined with reference to the type of insurance business written, the asset profile and the insurance cycle. It may be appropriate to consider several different time periods.

31/12/2004

PRU 2.3.55

Due regard should also be given to the historical experience of both the firm and the wider relevant industry and market when assigning values to the above inputs.

31/12/2004

PRU 2.3.56

The values assigned to each of the above inputs should be derived either stochastically, by assuming the value of an item can follow an appropriate probability distribution and by selecting appropriate values at the tail of the distribution, or deterministically, using appropriate prudent assumptions. For long-term insurance business which includes options or guarantees that change in value significantly in certain economic or demographic circumstances, a stochastic approach would normally be appropriate.

31/12/2004

PRU 2 Annex 1

Admissible assets in insurance

01/10/2005

(1)

Investments that are, or amounts owed arising from the disposal of:

(a)debt securities, bonds and other money and capital market instruments; (b) loans;(c)shares and other variable yield participations;(d) units in UCITS schemes, non-UCITS retail schemes, recognised schemes and any other collective investment scheme that invests only in admissible assets (including any derivatives or quasi-derivatives held by the scheme);(e) land, buildings and immovable property rights;(f) an approved derivative or quasi-derivative transaction that satisfies the conditions in PRU 4.3.5 R or an approved stock lending transaction that satisfies the conditions in PRU 4.3.36 R.

(2)

Debts and claims

(a)debts owed by reinsurers, including reinsurers' shares of technical provisions;(b) deposits with and debts owed by ceding undertakings;(c) debts owed by policyholders and intermediaries arising out of direct and reinsurance operations (except where overdue for more than 3 months and other than commission prepaid to agents or intermediaries);(d) for general insurance business only, claims arising out of salvage and subrogation;(e) for long-term insurance business only, advances secured on, and not exceeding the surrender value of, long-term insurance contracts issued by the insurer;(f) tax recoveries;(g) claims against compensation funds.

(3)

Other assets

(a) tangible fixed assets, other than land and buildings;(b) cash at bank and in hand, deposits with credit institutions and any other bodies authorised to receive deposits;(c) for general insurance business only, deferred acquisition costs;(d) accrued interest and rent, other accrued income and prepayments;(e) for long-term insurance business only, reversionary interests.

31/12/2005
Past version of Capital before 31/12/2005

PRU 2 Annex 2

Guidance on applications for waivers relating to implicit items Implicit items under the Act

01/10/2005

PRU 2.2.14 R does not permit implicit items to be included in the calculation of a firm's capital resources, except subject to a waiver under section 148 of the Act. Article 27(4) of the Consolidated Life Directive states that implicit items can be included in the calculation of a firm's capital resources, within limits, provided that the supervisory authority agrees. Certain implicit items, however, are not eligible for inclusion beyond 31 December 2009 (see paragraph 5). The FSA may be prepared to grant a waiver from PRU 2.2.14 Rto allow implicit items, in line with the purpose of the Consolidated Life Directive, and provided the conditions as set out in article 27(4) of the Consolidated Life Directive are met. Such a waiver would allow an implicit item to count towards the firm's capital resources available to count against its capital resources requirement (CRR) set out for realistic basis life firms in PRU 2.1.15 R and for regulatory basis only life firms in PRU 2.1.20 R. An implicit item may potentially count as tier one capital (but not core tier one capital) or tier two capital. Where a waiver is granted allowing an implicit item as tier one capital, the value of the implicit item so allowed must be included at stage B of the calculation in PRU 2.2.14 R. If the application of the value of the implicit item is restricted by PRU 2.2.20 R (1), which requires that at least 50% of a firm's tier one capital resources must be accounted for by core tier one capital, the remainder may be included at stage G of the calculation in PRU 2.2.14 R, subject to PRU 2.2.23 R. An implicit item treated as tier two capital will also be included at stage G of the calculation, again subject to PRU 2.2.23 R. Article 29(1) of the Consolidated Life Directive requires that implicit items be excluded from the capital eligible to cover the guarantee fund. Under PRU 2.2.17 R a firm must meet the guarantee fund from the sum of the items listed at stages A, B, G and H of the calculation in PRU 2.2.14 R less the sum of the items listed at stage E of the calculation in

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PRU Integrated Prudential sourcebook

Used in

Export part as

Application and general requirements

to follow

Adequacy of financial resources

Application

Purpose

Outline of other related provisions

Main Requirements

Stress tests and scenario analyses

Valuation

Application

Purpose

General requirements: accounting principles to be applied

Investments, derivatives and quasi-derivatives

Marking to market

Marking to model

Independent price verification

Valuation adjustments or reserves

Valuation adjustments or reserves

Shares in, and debts due from, related undertakings

Community co-insurance operations: general insurance business

Prudential risk management and associated systems and controls

Application

Purpose

How to interpret PRU 1.4

The role of systems and controls in a prudential context

The prudential responsibilities of senior management and the apportionment of those responsibilities

The delegation of responsibilities within the firm

Firms subject to risk management on a group basis

Business planning and risk management

Internal controls: introduction

Internal controls: segregation of duties

Internal controls: risk management committees

Internal controls: risk assessment

Internal audit

Management information

Record keeping

to follow

to follow

to follow

Actions for damages

Capital

Calculation of capital resources requirements

Application

Purpose

Main requirements

Calculation of the CRR

Calculation of the MCR

Calculation of the base capital resources requirement

Calculation of the general insurance capital requirement

Calculation of the long-term insurance capital requirement

Calculation of the ECR

Monitoring requirements

Capital resources

Application

Purpose

Principles underlying the definition of capital resources

Tier one capital

Upper and lower tier two capital

Deductions from capital

Calculation of capital resources

Limits on the use of different forms of capital

Characteristics of tier one capital

Core tier one capital: permanent share capital

Basic rules about redemption and cumulative coupons

Further guidance on redemption

Further guidance on coupons

Perpetual non-cumulative preference shares

Innovative tier one instruments: general rules

Innovative tier one instruments: loss absorbency

Innovative tier one instruments: Coupons

Innovative tier one instruments and other tier one instruments: step-ups

Innovative tier one instruments: principal stock settlement

Requirement to have sufficient unissued stock

Notifying the FSA of the issue and redemption of tier one instruments

Non standard capital instruments

Step-ups