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GENPRU 1.2 Adequacy of financial resources

Application

GENPRU 1.2.1RRP

This section applies to:

  1. (1)

    a BIPRU firm;

  2. (2)

    an insurer, unless it is:

    1. (a)

      a non-directive friendly society; or

    2. (b)

      a Swiss general insurer; or

    3. (c)

      an EEA-deposit insurer; or

    4. (d)

      an incoming EEA firm; or

    5. (e)

      an incoming Treaty firm; and

  3. (3)

    a firm to which GENPRU 1.2.2 R applies.

GENPRU 1.2.2R

The firms referred to in GENPRU 1.2.1R (3) are:

  1. (1)

    an incoming EEA firm which:

    1. (a)

      is a full BCD credit institution; and

    2. (b)

      has a branch in the United Kingdom; and

  2. (2)

    a third country BIPRU firm which:

    1. (a)

      is a bank; and

    2. (b)

      has a branch in the United Kingdom.

GENPRU 1.2.3R

This section applies to a firm in GENPRU 1.2.2 R in relation to liquidity risk only. Accordingly, for such a firm, the systems, processes and resources required by this section are only those that are required with respect to liquidity risk.

GENPRU 1.2.4R

For a firm described in GENPRU 1.2.2 R, this section applies only with respect to the branch.

GENPRU 1.2.5R

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.

GENPRU 1.2.6R

If an insurer carries on:

  1. (1)

    long-term insurance business; and

  2. (2)

    general insurance business;

This section applies separately to each type of business.

GENPRU 1.2.7G

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

GENPRU 1.2.8G

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

GENPRU 1.2.9G

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, the requirement in the general stress and scenario testing rule, insofar as it applies to liquidity, 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 an incoming EEA firm, the application of this section is further restricted by GENPRU 1.2.5 R.

GENPRU 1.2.10G

The scope of application of this section is not restricted to insurers that are subject to the relevant EC Directives.

GENPRU 1.2.11GRP

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 and so, except as described in GENPRU 1.2.8 G, this section applies to a firm in relation to the whole of its business. In the case of a UCITS investment firm this means that this section is not limited to designated investment business excluding scheme management activity. It also applies to scheme management activity and to activities that are not designated investment business.

Purpose

GENPRU 1.2.12GRP

Adequate financial resources and adequate systems and controls are necessary for the effective management of prudential risks. This section therefore has requirements relating to both of these topics.

GENPRU 1.2.13GRP

This section amplifies Principle 4, under which a firm must maintain adequate financial resources. It is concerned with the adequacy of the financial resources that 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.

GENPRU 1.2.14GRP

In the case of a bank or building society this section implements Article 123 and (in part) Annex XI of the Banking Consolidation Directive. In the case of a BIPRU investment firm this section implements Article 34 of the Capital Adequacy Directive so far as that Article applies Article 123 of the Banking Consolidation Directive.

GENPRU 1.2.15GRP

This section also has 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 that the firm considers necessary. GENPRU 1.2.60 R provides that a firm should document that assessment. The FSA will review that assessment as part of its own assessment of the adequacy of a firm's capital under its supervisory review and evaluation process (SREP). When forming a view of any individual capital guidance to be given to the firm, the FSA will also review the ARROW risk assessment and any other issues arising from day-to-day supervision. 2

2
GENPRU 1.2.16GRP

This section also has 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.

GENPRU 1.2.17G

The basic requirements in this section are drafted to apply to a firm on a solo basis. This section then goes on to describe when its requirements do and do not apply on a solo basis and on a consolidated basis (see GENPRU 1.2.45 R to GENPRU 1.2.47 R and GENPRU 1.2.57 R to GENPRU 1.2.58 R). It also sets out some details about how the solo requirements are adjusted when they are applied on a consolidated basis (see GENPRU 1.2.48 R to GENPRU 1.2.56 G and GENPRU 1.2.29 G).

Outline of other related provisions

GENPRU 1.2.18G

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

GENPRU 1.2.19G
  1. (1)

    BIPRU 2.2 (Internal capital adequacy standards) and INSPRU 7.1 (Individual capital assessment) set out detailed guidance on how a firm should carry out the assessment referred to in GENPRU 1.2.15 G. The more thorough, objective, and prudent a firm's assessment is, and can be demonstrated as being, the more reliance the FSA will be able to place on the results of that assessment.

  2. (2)

    BIPRU 2.2 and INSPRU 7.1also have information on how the FSA will review and respond to the assessments referred to in GENPRU 1.2.15 G. In particular they deal with the giving of individual capital guidance to a firm, which is guidance about the amount and quality of capital resources that the FSA thinks a firm should hold under the overall financial adequacy rule as it applies on a solo level and a consolidated level.

GENPRU 1.2.20G

SYSC sets out general rules and guidance on the establishment and maintenance of systems and controls.

GENPRU 1.2.21G

  1. (1)

    SYSC 11 sets out material on systems and controls that apply specifically to liquidity risk.

  2. (2)

    Chapters LM and LS of IPRU(BANK) contain guidance on the overall financial adequacy rule so far as it relates to adequate liquidity for banks and the firms to which GENPRU 1.2.2 R (Application of this section to certain non-EEA firms) applies.

  3. (3)

    Chapter 5 of volume 1 of IPRU(BSOC) contains guidance and an evidential provision on the overall financial adequacy rule so far as it relates to adequate liquidity for a building society.

  4. (4)

    SYSC 11.1.21 E is an evidential provision relating to the general stress and scenario testing rule concerning stress testing and scenario analyses. SYSC 11.1.24 E is evidential provision relating to the overall Pillar 2 rule about contingency funding plans.

  5. (5)

    GENPRU 2.2 (Adequacy of financial resources) requires certain BIPRU investment firms to deduct illiquid assets when calculating their capital resources.

GENPRU 1.2.22G

BIPRU 2.3 contains rules and guidance on interest rate risk in the non-trading book. That material elaborates on the general obligation in the overall Pillar 2 rule.

GENPRU 1.2.23G

For a BIPRU firm using a VaR model BIPRU 7.10.72 R (Risk management standards: Stress testing) sets out certain stress tests that the firm should carry out.

GENPRU 1.2.24G

BIPRU 10.6.22 R (Stress testing of credit risk concentrations) sets out further stress tests that a firm should carry out if it uses certain approaches to collateral for the purposes of the rules about concentration risk.

GENPRU 1.2.25G

For a BIPRU firm using the IRB approach BIPRU 4.3.39 R to BIPRU 4.3.40 R set out a recession credit rating migration stress test that the firm should carry out. Further rules and guidance on such stress tests are set out in BIPRU 2.2 (Internal capital adequacy standards).

Requirement to have adequate financial resources

GENPRU 1.2.26RRP

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.

GENPRU 1.2.27GRP

The liabilities referred to in the overall financial adequacy rule include a firm's contingent and prospective liabilities. It 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 includesliabilities or costs that arise as a consequence of strategies other than continuing asa going concern. Italso includesclaims 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.

GENPRU 1.2.28GRP

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.

GENPRU 1.2.29GRP

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. 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. SYSC 11.1.24 E is an evidential provision relating to the overall financial adequacy rule concerning contingency funding plans.

Systems, strategies, processes and reviews

GENPRU 1.2.30RRP

A firm must have in place sound, effective and complete processes, strategies and systems:

  1. (1)

    to assess and maintain on an ongoing basis the amounts, types and distribution of financial resources, capital resources and internal capital that it considers adequate to cover:

    1. (a)

      the nature and level of the risks to which it is or might be exposed;

    2. (b)

      the risk in the overall financial adequacy rule; and

    3. (c)

      the risk that the firm might not be able to meet its CRR in the future; and

  2. (2)

    that enable it to identify and manage the major sources of risks referred to in (1), including the major sources of risk in each of the following categories1 where they are relevant to the firm given the nature and scale of its business:

    1. (a)

      credit risk;

    2. (b)

      market risk;

    3. (c)

      liquidity risk;

    4. (d)

      operational risk;

    5. (e)

      insurance risk;

    6. (f)

      concentration risk;

    7. (g)

      residual risk;

    8. (h)

      securitisation risk;

    9. (i)

      business risk;

    10. (j)

      interest rate risk (including, in the case of a BIPRU firm, interest rate risk in the non-trading book); and

    11. (k)

      pension obligation risk.

GENPRU 1.2.31RRP

  1. (1)

    This rule defines some of the terms used in the overall Pillar 2 rule.

  2. (2)

    Residual risk means the risk that credit risk mitigation techniques used by the firm prove less effective than expected.

  3. (3)

    Securitisation risk includes the risk that the capital resources held by a firm in respect of assets which it has securitised are inadequate having regard to the economic substance of the transaction, including the degree of risk transfer achieved.

  4. (4)

    Business risk means any risk to a firm arising from changes in its business, including the risk that the firm may not be able to carry out its business plan and its desired strategy.

  5. (5)

    Pension obligation risk is the risk to a firm caused by its contractual or other liabilities to or with respect to a pension scheme (whether established for its employees or those of a related company or otherwise). It also means the risk that the firm will make payments or other contribution to or with respect to a pension scheme because of a moral obligation or because the firm considers that it needs to do so for some other reason.

GENPRU 1.2.32GRP

  1. (1)

    This paragraph gives guidance on some of the terms used in the overall Pillar 2 rule.

  2. (2)

    Insurance risk refers to the inherent uncertainties as to the occurrence, amount and timing of insurance liabilities.

  3. (3)

    Interest rate risk in the non-trading book is explained in BIPRU 2.3 (Interest rate risk in the non-trading book).

  4. (4)

    In a narrow sense, business risk is the risk to a firm that it suffers losses because its income falls or is volatile relative to its fixed cost base. However, in a broader sense, it is exposure to a wide range of macro-economic, geopolitical, industry, regulatory and other external risks that might deflect a firm from its desired strategy and business plan. GENPRU 1.2.73 G provides further guidance on business risk.

  5. (5)

    Further material on pension obligation risk can be found in GENPRU 1.2.79 GGENPRU 1.2.86 G.

GENPRU 1.2.33RRP
  1. (1)

    This rule amplifies some of the obligations in the overall Pillar 2 rule.

  2. (2)

    In the case of a BIPRU firm the processes, strategies and systems relating to concentration risk must include those necessary to ensure compliance with BIPRU 10 (Concentration risk requirements).

  3. (3)

    As part of its obligations in respect of market risk, a BIPRU firm must consider whether the value adjustments and provisions taken for positions and portfolios in the trading book enable the firm to sell or hedge out its positions within a short period without incurring material losses under normal market conditions.

  4. (4)

    The processes, strategies and systems required by the overall Pillar 2 rule must take into account stress tests and scenario analyses that the firm is required to carry out under any other provision of the Handbook.

GENPRU 1.2.34GRP

In the overall Pillar 2 rule , internal capital refers to the financial resources of a firm which it treats as being held against the risks listed in the overall Pillar 2 rule. The obligation in that rule to assess the distribution of such capital refers, in relation to a firm making an assessment on a solo basis, for example, to the need to take account of circumstances where part of a firm's financial resources are held by a branch of that firm which are subject to restrictions on its ability to transfer that capital. An assessment of internal capital distribution might also take account of such of a firm's financial resources as may be ring-fenced in the event of its insolvency.

GENPRU 1.2.35RRP

The processes, strategies and systems required by the overall Pillar 2 rule must be comprehensive and proportionate to the nature, scale and complexity of the firm's activities.

GENPRU 1.2.36RRP

As part of its obligations under GENPRU 1.2.30R (1) (Main requirement relating to risk processes, strategies and systems), a firm must identify separately the amount of tier one capital, tier two capital, tier three capital, other capital eligible to form part of its capital resources and each category of capital (if any) that is not eligible to form part of its capital resources which it considers adequate for the purposes described in GENPRU 1.2.30R (1).

GENPRU 1.2.37RRP

The processes and systems required by the overall Pillar 2 rule must:

  1. (1)

    include an assessment of how itintends to deal with each of the major sources of risk identified in accordance with GENPRU 1.2.30R (2); and

  2. (2)

    take into account the impact of diversification effects and how such effects are factored into the firm's systems for measuring risks.

GENPRU 1.2.38GRP

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. A firm, should, in accordance with GENPRU 1.2.60 R (Documentation of risk assessments), document the approaches taken to manage these risks.

GENPRU 1.2.39RRP

A firm must:

  1. (1)

    carry out regularly the assessments required by the overall Pillar 2 rule; and

  2. (2)

    carry out regularly assessments of the processes, strategies and systems required by the overall Pillar 2 rule to ensure that they remain compliant with GENPRU 1.2.35 R.

GENPRU 1.2.40GRP

A firm should carry out assessments of the sort described in the overall Pillar 2 rule and GENPRU 1.2.39 R at least annually, or more frequently if changes in the business, strategy, nature or scale of its activities or operational environment suggest that the current level of financial resources is no longer adequate. 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.

GENPRU 1.2.41G

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.

Stress and scenario tests

GENPRU 1.2.42RRP

  1. (1)

    As part of its obligation under the overall Pillar 2 rule, a firm must, for each of the major sources of risk identified in accordance with GENPRU 1.2.30R (2), 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. (a)

      take reasonable steps to identify an appropriate range of realistic adverse circumstances and events in which the risk identified crystallises; and

    2. (b)

      estimate the financial resources the firm would need in each of the circumstances and events considered in order:

      1. (i)

        to be able to meet its liabilities as they fall due;

      2. (ii)

        to be able to meet the CRR;

      3. (iii)

        to carry out the plans referred to in GENPRU 1.2.37R (1); and

      4. (iv)

        otherwise to meet, to the extent that it considers necessary, that major source of risk.

  2. (2)

    In carrying out the stress tests and scenario analyses in (1), a BIPRU firm with an IRB permission must incorporate and take into account the stress tests required to be carried out under BIPRU 4.3.39 R to BIPRU 4.3.40 R (Stress tests used in assessment of capital adequacy).

  3. (3)

    In carrying out the stress tests and scenario analyses in (1), a BIPRU firm must incorporate and take into account any other stress tests and scenario analyses that it is required to carry out under any other provision of the Handbook.

GENPRU 1.2.43GRP

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 GENPRU 1.2.30R (2) (Main requirement relating to risk processes, strategies and systems) 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. SYSC 11.1.21 E is an evidential provision relating to the general stress and scenario testing rule concerning scenario analysis in relation to liquidity risk.

Application of this section on a solo and consolidated basis: General

GENPRU 1.2.44G

  1. (1)

    GENPRU 1.2.45 RGENPRU 1.2.56 G explain when the ICAAP rules apply on a solo basis and when they apply on a consolidated basis. This material also explains how the ICAAP rules are adjusted to apply on a consolidated basis.

  2. (2)

    GENPRU 1.2.57 RGENPRU 1.2.59 R provide that the overall financial adequacy rule always applies on a solo basis. They also explain when and how it applies on a consolidated basis.

Application of this section on a solo and consolidated basis: Processes and tests

GENPRU 1.2.45R

If an insurer is a member of an insurance group and INSPRU 6.1.9 R, INSPRU 6.1.10 R or INSPRU 6.1.15 R (Requirement to maintain group capital) apply to it with respect to that insurance group the ICAAP rules:

  1. (1)

    apply to that insurer on a consolidated basis; and

  2. (2)

    do not apply to it on a solo basis.

GENPRU 1.2.46R

The ICAAP rules do not apply on a solo basis to a BIPRU firm to which the ICAAP rules:

  1. (1)

    apply on a consolidated basis under BIPRU 8.2.1 R (Basic consolidation rule for a UK consolidation group); or

  2. (2)

    apply on a sub-consolidated basis under BIPRU 8.3.1 R (Basic consolidation rule for a non-EEA sub-group).

GENPRU 1.2.47R

The ICAAP rules apply on a solo basis:

  1. (1)

    to an insurer to which those rules do not apply on a consolidated basis under GENPRU 1.2.45 R;

  2. (2)

    to a BIPRU investment firm to which those rules do not apply on a consolidated or sub-consolidated basis as referred to in GENPRU 1.2.46 R (including a BIPRU investment firm with an investment firm consolidation waiver); and

  3. (3)

    a firm referred to in GENPRU 1.2.2 R (Application of this section to certain non-EEA firms).

GENPRU 1.2.48R

The requirements of the ICAAP rules as they apply on a consolidated basis must be carried out on the basis of the consolidated position of:

  1. (1)

    (if GENPRU 1.2.45 R applies) that insurance group;

  2. (2)

    (if BIPRU 8.2.1 R (Basic consolidation rule for a UK consolidation group) applies) the UK consolidation group of which the firm is a member; and

  3. (3)

    (if BIPRU 8.3.1 R (Basic consolidation rule for a non-EEA sub-group) applies) the non-EEA sub-group of which the firm is a member.

GENPRU 1.2.49RRP

  1. (1)

    In accordance with the general principles in GENPRU 1.2.48 R and BIPRU 8 (Group risk – consolidation), for the purpose of the ICAAP rules as they apply on a consolidated basis:

    1. (a)

      the firm must ensure that the relevant group as defined in (2) have the processes, strategies and systems required by the overall Pillar 2 rule;

    2. (b)

      the risks to which the overall Pillar 2 rule and the general stress and scenario testing rule refer are those risks as they apply to each member of the relevant group;

    3. (c)

      the reference in the overall Pillar 2 rule to amounts and types of financial resources, capital resources and internal capital (referred to in this rule as resources) must be read as being to the amounts and types that the firm considers should be held by the members of the relevant group as defined in (2);

    4. (d)

      other references to resources must be read as being to resources of the members of the relevant group as defined in (2);

    5. (e)

      references to the CRR are to the consolidated capital requirements applicable to the relevant group under BIPRU 8 (Group risk - consolidation) or, as the case may be, INSPRU 6 (Group risk: Insurance groups);

    6. (f)

      the reference in the overall Pillar 2 rule to the distribution of resources must be read as including a reference to the distribution between members of the relevant group as defined in (2); and

    7. (g)

      the reference in the overall Pillar 2 rule to the overall financial adequacy rule must be read as being to that rule as adjusted under GENPRU 1.2.59 R (Application of the overall financial adequacy rule on a consolidated basis).

  2. (2)

    For the purpose of this rule the relevant group is the group referred to in GENPRU 1.2.48 R and the members of that group are those undertakings that are included in the scope of consolidation with respect to theinsurance group, UK consolidation group or, as the case may be, non-EEA sub-group in question.

GENPRU 1.2.50GRP

GENPRU 1.2.49 R means that non-financial members of the firm's group are excluded from the group assessment. Notwithstanding the scope of GENPRU 1.2.49 R, a firm should nevertheless take account of risks arising from the activities of those excluded members in its overall assessment of risk.

GENPRU 1.2.51RRP

  1. (1)

    This rule relates to the assessment of the amounts, types and distribution of financial resources, capital resources and internal capital (referred to in this rule as "resources") under the overall Pillar 2 rule as applied on a consolidated basis and to the assessment of diversification effects as referred to in GENPRU 1.2.37R (2) as applied on a consolidated basis.

  2. (2)

    A firm must be able to explain how it has aggregated the risks referred to in the overall Pillar 2 rule and the resources required by each member of the relevant group as referred to in GENPRU 1.2.49R (2) and how it has taken into account any diversification benefits with respect to the group in question.

  3. (3)

    In particular, to the extent that the transferability of resources affects the assessment in (2), a firm must be able to explain how it has satisfied itself that resources are transferable between members of the group in question in the stressed cases and the scenarios referred to in the general stress and scenario testing rule.

GENPRU 1.2.52RRP

  1. (1)

    A firm must allocate the total amount of financial resources, capital resources and internal capital identified as necessary under the overall Pillar 2 rule (as applied on a consolidated basis) between different parts of the relevant group (as defined in GENPRU 1.2.49 R). GENPRU 1.2.36 R (Identifying different tiers of capital) does not apply to this allocation.

  2. (2)

    The firm must carry out the allocation in (1) in a way that adequately reflects the nature, level and distribution of the risks to which the group is subject and the effect of any diversification benefits.

GENPRU 1.2.53RRP

A firm must also allocate the total amount of financial resources, capital resources and internal capital (referred to in this rule as "resources") identified as necessary under the overall Pillar 2 rule as applied on a consolidated basis between each firm which is a member of the relevant group (as defined in GENPRU 1.2.49 R) on the following basis:

  1. (1)

    the amount allocated to each firm must be decided on the basis of the principles in GENPRU 1.2.52R (2); and

  2. (2)

    if the process in (1) were carried out for each group member, the total so allocated would equal the total amount of resources identified as necessary under the overall Pillar 2 rule as applied on a consolidated basis.

GENPRU 1.2.54GRP

A firm to which the ICAAP rules apply on a consolidated basis need not prepare a consolidated basis assessment if such an assessment has been prepared by another member of its group. Where that is the case, a firm may adopt such an assessment as its own. A firm nevertheless remains responsible for the assessment.

GENPRU 1.2.55GRP

The purpose of GENPRU 1.2.51 RGENPRU 1.2.53 R is to enable the FSA to assess the extent, if any, to which a firm's assessment, calculated on a consolidated basis, is lower than it would be if each separate legal entity were to assess the amount of capital it would require to mitigate its risks (to the same level of confidence) were it not part of a group subject to consolidated supervision under BIPRU 8 (Group risk - consolidation) or INSPRU 6.1 (Group risk: Insurance groups). The reason the FSA wishes to make this assessment is so that individual capital guidance which it gives is fair and comparable as between different firms and groups. Group diversification benefits which a firm might assert exist can be a material consideration in a capital adequacy assessment. Understanding the methods used to aggregate the different risks (for example, the correlation assumptions) is crucial to a proper evaluation of such benefits.

GENPRU 1.2.56GRP

Whereas a single legal entity can generally use its capital to absorb losses wherever they arise, there are often practical and legal restrictions on the ability of a group to do so. For instance:

  1. (1)

    capital which is held by overseas regulated firms may not be capable of being remitted to a firm in the UK which has suffered a loss;

  2. (2)

    a firm which is insolvent or likely to become so may be obliged to look to the interests of its creditors first before transferring capital to other group companies; and

  3. (3)

    a parent company may have to balance the interests of its shareholders against the protection of the creditors of a subsidiary undertaking which is or might become insolvent and may, rationally, conclude that a subsidiary undertaking should be allowed to fail rather than provide capital to support it.

Application of this section on a solo and consolidated basis: Adequacy of resources

GENPRU 1.2.57RRP

The overall financial adequacy rule applies to a firm on a solo basis whether or not it also applies to the firm on a consolidated basis.

GENPRU 1.2.58RRP

The overall financial adequacy rule applies to a firm on a consolidated basis if the ICAAP rules apply to it on a consolidated basis.

GENPRU 1.2.59RRP

  1. (1)

    When the overall financial adequacy rule applies on a consolidated basis, the firm must ensure that at all times its group maintains 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 the liabilities of any members of its group cannot be met as they fall due.

  2. (2)

    The group referred to in (1) is the relevant group as defined in GENPRU 1.2.49 R.

  3. (3)

    The members of the group referred to in (1) must be identified in accordance with GENPRU 1.2.49 R.

Documentation of risk assessments

GENPRU 1.2.60RRP

A firm must make a written record of the assessments required under this section. These assessments include assessments carried out on a consolidated basis and on a solo basis. In particular it must make a written record of:

  1. (1)

    the major sources of risk identified in accordance with GENPRU 1.2.30R (2) (Main requirement relating to risk processes, strategies and systems);

  2. (2)

    how it intends to deal with those risks; and

  3. (3)

    details of the stress tests and scenario analyses carried out and the resulting financial resources estimated to be required in accordance with the general stress and scenario testing rule.

GENPRU 1.2.61RRP

A firm must retain the records of its assessments referred to in GENPRU 1.2.60 R for at least three years.

GENPRU 1.2.62GRP

Where a firm assesses the adequacy of its CRR in its particular circumstances in accordance with BIPRU 2.2 (Internal capital adequacy standards) and INSPRU 7.1 (Individual capital assessment) as a basis for deciding what financial resources are adequate, it should include this in the documentation produced in accordance with GENPRU 1.2.60 R.

Additional guidance on stress tests and scenario analyses

GENPRU 1.2.63GRP

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

GENPRU 1.2.64GRP

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 financial position.

GENPRU 1.2.65GRP

Scenario analysis typically refers to a wider range of parameters being varied at the same time. Scenario analyses often examine the impact of adverse 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.

GENPRU 1.2.66GRP

There are three broad purposes of stress testing and scenario analysis. Firstly, it can be used as a means of quantifying how much capital might be absorbed if an adverse event or events occurred. As such it represents a simple ‘what if’ approach to estimating exposure to risks. This might be a proportionate approach to risk management for an unsophisticated business. Secondly, it can be used to provide a check on the outputs and accuracy of risk models; particularly, in identifying non-linear effects when aggregating risks. Thirdly, it can be used to explore the sensitivities in longer term business plans and how capital needs might change over time.

GENPRU 1.2.67G

The general stress and scenario testing rule 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. (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. (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.

GENPRU 1.2.68GRP

Subject to GENPRU 1.2.76 G, the purpose of stress tests and scenario analyses under the general stress and scenario testing rule 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.

GENPRU 1.2.69GRP

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

  1. (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. (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.

GENPRU 1.2.70GRP

The time horizon over which stress tests and scenario analysisshould be carried out shoulddepend on the maturity and liquidity of the positions stressed. For example, for the market risk arising from the holding of investments, this shoulddepend upon:

  1. (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. (2)

    the extent to which the market in those assets is sufficiently liquid (and would remain liquid in the changed circumstances contemplated in the stress test or scenario analysis) to allow the firm, if needed, to sell, hedge or otherwise mitigate the risks relating to its holding so as to prevent or reduce exposure to future price fluctuations.

GENPRU 1.2.71GRP

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

  1. (1)

    the nature, scale and mix of its future activities; and

  2. (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).

GENPRU 1.2.72GRP

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

  1. (1)

    only include financial resources that could reasonably be relied upon as being available in the circumstances of the identified scenario; and

  2. (2)

    take account of any legal or other restriction on the use of financial resources.

GENPRU 1.2.73G

  1. (1)

    A firm should conduct stress tests and scenario analyses which project its financial position (both profitability and balance sheet position) so as to estimate both its capital resources and capital resource requirements throughout an economic or business cycle.

  2. (1A)

    For an insurer, these tests and analyses are in addition to those that may be used for the ICA (see INSPRU 7.1.10 G and INSPRU 7.1.68 G). Projections should be made on different bases, including ones which are consistent with the business plan, as well as others using 'realistically adverse' alternative scenarios. In considering the tests and analyses to be used for the purposes of these projections, an insurer should have regard to the matters mentioned below.2

    1. (a)

      As with the ICA, it is for the insurer to identify an appropriate range of adverse circumstances and events. As the projections are being assessed as part of business planning, the FSA would expect stresses and scenarios to be more likely than the extreme conditions covered by an ICA. As a guide, stresses and scenarios with a probability of once in a 25 year period would be useful as a reference when an insurer discusses projections of its financial position with the FSA (see also GENPRU 1.2.75G (3)). 2

    2. (b)

      Business risk is likely to be a more significant feature in projecting an insurer's financial position than in its ICA (see GENPRU 1.2.31 R and GENPRU 1.2.32 G).2

    3. (c)

      The treatment of new business is likely to be different for projecting an insurer's financial position than in its ICA. In the former, this should be based on the firm’s business plan, but flexed to incorporate potential changes in trading conditions and strategy. In the latter, account should be taken of the effects of a closure to new business (see GENPRU 1.2.27 G, GENPRU 1.2.73G (3) and INSPRU 7.1.16 G to INSPRU 7.1.19 G).2

    4. (d)

      Methods that are more approximate than used for an ICA may be appropriate for projecting elements of an insurer's financial position (e.g. the with-profits insurance capital component for realistic basis life firms).2

  3. (2)

    A firm will need to consider the cycles it is most exposed to and whether these are general economic cycles or specific to particular markets, sectors or industries. The length of time over which such projections would be appropriate will therefore vary, but typically might be between three and five years.

  4. (3)

    The projections should be based on the firm's business plan, but flexed to incorporate adverse trading conditions and any changes in strategy which the firm could and would take in response to those conditions.

  5. (4)

    Changes in strategy might be necessary for instance because capital needed to be able to continue its business at existing volumes is eroded. A firm may also alter its capital management strategy to restrict distributions of profits or to raise additional capital. The combined effect on capital and retained earnings should be estimated. A firm should document how it would react to such economic and business risks.

  6. (5)

    The FSA will take the projections referred to in this paragraph and the plan referred to in (4) into account as part of its SREP. The purpose of examining them is to enable the FSA to judge, at an appropriate level of certainty, whether the firm will be able to meet its obligations throughout a recession.

GENPRU 1.2.74GRP

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 a reasonable degree of 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.

GENPRU 1.2.75GRP

  1. (1)

    A firm should assess the nature and severity of the economic recession or business cycle changes which are relevant to it given the nature and scale of its business. When projecting its capital resources and CRR a firm should consider a range of stresses and scenarios both in nature and severity.

  2. (2)

    Stress and scenario analyses should, in the first instance, be aligned with the risk appetite of the firm and the calibration of such stress and scenario analyses should be reconciled backto a clear statement setting out the premise upon which the firm's internal capital assessment under the overall Pillar 2 rule is based.

  3. (3)

    A firm with an IRB permission should ensure that the range of stresses and scenarios considered encompasses the severity of recession specified in BIPRU 4.3.40 R (Stress tests used in assessment of capital adequacy), which is one that might be expected to occur once in a 25 year period. Other firms may also find that this a useful reference point when discussing their assessments with the FSA.

  4. (4)

    A firm may also consider scenarios in which the amount of capital it currently holds would be exhausted. This would provide useful information about the reasonableness or remoteness of such scenarios arising. Where a firm uses capital models as part of its risk management processes, considering the sensitivity of model results to variations around the most likely ruin scenario focuses testing on the most relevant scenarios.

GENPRU 1.2.76GRP

A firm should use the results of its stress testing and scenario analysis not only to assess capital needs, but also to decide if measures should be put in place to minimise the adverse effect on the firm if the risk covered by the stress or scenario test actually materialises. Such measures might be a contingency plan or might be more concrete risk mitigation steps.

GENPRU 1.2.77G

Additional guidance on stress tests and scenario analyses for the assessment of capital resources is available in BIPRU 2.2 (Internal capital adequacy standards) and INSPRU 7.1 (Individual capital assessment).

GENPRU 1.2.78G

Additional guidance in relation to stress tests and scenario analysis for liquidity risk is available in SYSC 11 (Liquidity risk systems and controls).

Pension obligation risk

GENPRU 1.2.79G

GENPRU 1.2.80 GGENPRU 1.2.86 G contain guidance on the assessment required by GENPRU 1.2.30R (2)(k) (Pension risk).

GENPRU 1.2.80GRP

The pension scheme itself (i.e. the scheme's assets and liabilities) is not the focus of the risk assessment; it is the firm's obligations towards the pension scheme which is.

GENPRU 1.2.81GRP

If a firm has a current funding obligation in excess of normal contributions or there is a risk that such a funding obligation will arise then, when calculating available capital resources, it should reverse out any accounting deficit and replace this in its capital adequacy assessment with its best estimate, calculated in discussion with the scheme's actuaries or trustees, of the cash that will need to be paid into the scheme in addition to normal contributions over the foreseeable future. This may differ from the approach taken in assessing pension scheme risks for the purposes of calculating resources to meet the CRR, where a firm may not need to consider funding obligations beyond the next five years.

GENPRU 1.2.82GRP

1A firm should assess the risks that increase its obligations towards the pension scheme that might lead to the firm not being able to pay its other liabilities as they fall due.

GENPRU 1.2.83GRP

A firm may wish to consider the following scenarios:

  1. (1)

    one in which the firm gets into difficulties with an effect on its ability to fund the pension scheme; and

  2. (2)

    one in which the pension scheme position deteriorates (for example, because investment returns fall below expected returns or because of increases in life expectancy) with an effect on the firm's funding obligations; taking into account the management actions the firm could and would take.

GENPRU 1.2.84GRP

Scenarios in which a firm's employees suffer a loss or members of a pension scheme suffer a loss do not necessarily affect the firm's ability to pay its liabilities as they fall due.

GENPRU 1.2.85GRP

A firm should consider issues such as:

  1. (1)

    the extent to which trustees of the pension scheme or a pension regulator (such as the one created under the Pensions Act 2004) can compel a certain level of contributions or a one-off payment in adverse financial situations or in order to meet the minimum legal requirements under the scheme's trust deed and rules or under the applicable laws relating to the pension scheme;

  2. (2)

    whether the valuation bases used to set pension scheme contribution rates are consistent with the firm's current business plans and anticipated changes in the workforce; and

  3. (3)

    which valuation basis is appropriate given the expected investment return on scheme assets and actions the firm can take if those returns do not materialise.

GENPRU 1.2.86GRP

A firm should carry out analyses only to a degree of sophistication and complexity which is commensurate with the materiality of its pension risks.