INSPRU 3.1 Market risk in insurance

INSPRU 3.1 addresses the impact of market risk on insurance business in the ways set out below:

1. (1)

   Any firm that carries on long-term insurance business which is a regulatory basis only life firm 2must comply with the resilience capital requirement. This requires the firm to hold capital to cover market risk. The resilience capital requirement is dealt with in INSPRU 3.1.9 G to INSPRU 3.1.26 R.

2. (2)

   For a firm that carries on long-term insurance business, the assets that it must hold must be of a value sufficient to cover the firm's technical provisions and other long-term insurance liabilities. INSPRU 1.2 contains rules and guidance as to the methods and assumptions to be used in calculating the mathematical reserves. One of these assumptions is the assumed rate of interest to be used in calculating the present value of future payments by or to a firm. INSPRU 3.1.28 R to INSPRU 3.1.48 G set out the methodology to be used in relation to long-term insurance liabilities.

3. (3)

   Firms carrying on either long-term insurance business or general insurance business are also subject to currency risk. That is, the risk that fluctuations in exchange rates may impact adversely on a firm. INSPRU 3.1.49 G to INSPRU 3.1.56 G set out the requirements a firm must meet so as to cover this risk.

4. (4)

   For a firm carrying on general insurance business, the Enhanced Capital Requirement already captures some elements of market risk. In addition, the requirements as to the assumed rate of interest used in calculating the present value of general insurance liabilities are contained in the insurance accounts rules, and these requirements are outlined in INSPRU 3.1.27 G.

5. (5)

   Firms carrying on long-term insurance business that have property-linked liabilities or index-linked liabilities must cover these liabilities by holding appropriate assets. INSPRU 3.1.57 R and INSPRU 3.1.58 R set out these cover requirements.

6. (6)

   The Reinsurance Directive applies to pure reinsurers "prudent person" investment principles in relation to the investment of their assets. INSPRU 3.1.61A R sets out these principles.

For the purposes of INSPRU 3.1.57 R and INSPRU 3.1.58 R, a firm is not permitted to hold different assets and to cover the mismatch by holding excess assets.

If a firm has incurred a policy liability which cannot be exactly matched by appropriate assets (for example the Limited Price Index (LPI)), the firm should seek to match assets that at least cover the liabilities. For example, an LPI limited to 5% per annum may be matched by an RPI bond or a fixed interest investment matching cash flows increasing at 5% per annum compound. Orders made by the Department for Work and Pensions under section 148 of the Social Security Administration Act 1992, and which are limited to 5% per annum, may also be matched by a fixed interest investment matching cash flows increasing at 5% per annum compound (see also INSPRU 3.1.61-A G).4

In selecting the appropriate cover, the firm should ensure that both credit risk, and the risk that the value or yield in the assets will not, in all circumstances, match fluctuations in the relevant index, are within acceptable limits. Rules and guidance relating to credit risk are set out in INSPRU 2.1.

4Where liabilities are linked to orders made under section 148 of the Social Security Administration Act 1992, firms are required by COBS 21.3.5R to notify the PRA10 before effecting any such business and to explain how the risks associated with this business will be safely managed. This requirement does not apply in respect of liabilities for which a limited revaluation premium has been paid to the Department for Work and Pensions so that the liability for revaluation, while still linked to section 148 orders, is limited to 5%. The risks may be mitigated by holding assets to cover an alternative index which is reasonably expected to at least cover the section 148 order (e.g. RPI plus a margin) over the duration of the link. The firm's exposure to an order under section 148 exceeding this index should be appropriately limited by putting a cap on the liabilities linked to the order so that risks are within acceptable limits.