INSPRU 1.2 Mathematical reserves

A number of the rules in this section require a firm to take into account its regulatory duty to treat customers fairly. In this section, references to such a duty are to the duty of a firm regulated by the FCA9 to pay due regard to the interests of its customers and to treat them fairly (see the FCA's9 Principle 6 in PRIN). This duty is owed to both policyholders and potential policyholders.

9A number of rules in this section are made by the FCA and the PRA. Some of the rules made by the FCA and PRA contain references to, or are reliant on, rules that are only made by the PRA. Firms should consider GEN 2.2.13A R (cross-references in the Handbook) and GEN 2.2.23 R to GEN 2.2.25 G (cutover: application of provisions made by both the FCA and the PRA) when applying these rules. In the context of mathematical reserves, the FCA rules ensure a firm takes into account its regulatory duty to treat customers fairly. Where an FCA rule refers to a PRA rule, GEN 2.2.13A R and GEN 2.2.23 R will apply so that the PRA rule is also made by the FCA to the extent necessary to make the FCA rule function but only to the extent of the FCA's powers and regulatory responsibilities.

INSPRU 1.2.10R (2) prohibits only arbitrary changes in methods and assumptions, that is, changes made without adequate reasons. Any such changes would hinder comparisons over time as to the amount of the mathematical reserves and so obscure trends in solvency and the emergence of surplus.

SYSC 14.1.53 R requires firms to maintain accounting and other records for a minimum of three years, or longer as appropriate. For the purposes of INSPRU 1.2.20 R, a period of longer than three years will be appropriate for a firm's long-term insurance business. In determining an appropriate period, a firm should have regard to:

1. (1)

   the detailed rules and guidance on record keeping in SYSC 14.1.51 G - SYSC 14.1.64 G;

2. (2)

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

3. (3)

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

A firm may include amounts recoverable from an ISPV in the cash flows to be valued in a prospective valuation if it obtains a waiver of INSPRU 1.2.28 R under sections 138A and 138B of the Act. The conditions that will need to be met, in addition to the statutory tests under section 138A(4) of the Act, before the PRA will consider granting such a waiver are set out in INSPRU 1.6.13 G to INSPRU 1.6.18 G.

All cash flows are to be valued using prudent assumptions in accordance with generally accepted actuarial practice. Cash flows may be omitted from the valuation calculations provided the reserves obtained as a result of leaving those cash flows out of the calculation are not less than would have resulted had all cash flows been included (see INSPRU 1.2.22R (2)(b)2). Provision for future expenses in respect of with-profits insurance contracts (excluding accumulating with-profits policies) may be made implicitly, using the net premium method of valuation (see INSPRU 1.2.43 R below). For the purposes of INSPRU 1.2.28R (1)(b)3, any charges included in expenses should be determined in accordance with the firm's regulatory duty to treat its customers fairly.

INSPRU 1.2.29R (4) requires regulatory basis only life firms to make allowance for any future annual bonus that a firm would expect to grant, assuming future experience is in line with the assumptions used in the calculation of the mathematical reserves. final bonuses do not have to be taken into consideration in these calculations except in relation to accumulating with-profits policies (see INSPRU 1.2.9 R). The calculations required for accumulating with-profits policies are set out in INSPRU 1.2.71R (1). For realistic basis life firms, except for accumulating with-profits policies, the mathematical reserves may be calculated without taking into account discretionary benefits, including both annual bonuses and final bonuses. For such firms full allowance for discretionary benefits is made in the calculation of the realistic value of liabilities (see INSPRU 1.3.105R (5)).

The rates of mortality or morbidity should contain prudent margins for adverse deviation (see INSPRU 1.2.13 R to INSPRU 1.2.19 G). In setting those rates, a firm should take account of:

1. (1)

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

   1. (a)

      adequately defining and identifying non-standard risks; and

   2. (b)

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

2. (2)

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

   1. (a)

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

   2. (b)

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

   3. (c)

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

3. (3)

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

   1. (a)

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

   2. (b)

      whether the data is reliable and has been appropriately validated;

4. (4)

   the availability and reliability of:

   1. (a)

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

   2. (b)

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

5. (5)

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

   1. (a)

      anticipated improvements in mortality;

   2. (b)

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

   3. (c)

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

   4. (d)

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

An additional provision for diseases covered by INSPRU 1.2.60G (5)(c) may be needed, in particular for unit-linked policies. In determining whether such a provision is needed a firm may take into consideration any ability to increase product charges commensurately (provided that such increase does not infringe on its regulatory duty to treat its customers fairly), but a provision would still be required for the period until such an increase could be brought into effect.

2A contract has a guaranteed surrender value where the policy wording states that a surrender value is payable and either provides for a minimum amount payable on surrender or sets out a method for calculating such an amount. For example, where a unit-linked contract provides for a surrender value equal to the value of the units allocated to the contract, the firm must establish mathematical reserves for that contract greater than or equal to the value of the units allocated at the valuation date.

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

1. (1)

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

2. (2)

   the right to increase cover on guaranteed terms;

3. (3)

   the right to a specified amount on surrender; and

4. (4)

   the right to a paid up value.

The firm should provide for the benefit which the firm anticipates the policyholder is most likely to choose. P2ast experience may be used as a guide, but only if this is likely to give a reasonable estimate of future experience. For example, past experience of the take-up of a cash payment option instead of an annuity would not be a reliable guide, if, in the past, market rates exceeded those guaranteed in the annuity but no longer do so. Similarly, past experience on the take-up of options may not be relevant in the light of the assumptions made in respect of future interest rates and mortality rates in the valuation of the benefits.

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

In accordance with INSPRU 1.2.7 R and INSPRU 1.2.13 R, take-up rates for guaranteed annuity options should be assessed on a prudent basis with assumptions that include margins for adverse deviation (see INSPRU 1.2.13 R to INSPRU 1.2.19 G) that take account of current experience and the potential for future change. The firm should reserve for option take-up at least at a prudent margin over current experience for options shortly to vest. For longer term options where the option becomes increasingly valuable in the future due to projected mortality improvements, increased take-up rates should be assumed. In view of the growing uncertainty over take-up rates for projections further in the future, for guaranteed annuity option dates 20 years or more ahead at least a 95% take-up rate assumption should be made.

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

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

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

INSPRU 1.2.71R (1) applies only to accumulating with-profits policies; INSPRU 1.2.71R (2) applies to any other type of policy, including non-profit insurance contracts. In INSPRU 1.2.71R (1)(a) a firm must take into consideration, for example, a market value adjustment where such an adjustment has been described in representations made to policyholders by the firm. However, any discretionary adjustment, such as a market value adjustment, must not be included in the amount calculated in INSPRU 1.2.71R (1)(b).