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PRU 2.3 Individual Capital Assessment

Application

PRU 2.3.1R

PRU 2.3 applies to an insurer unless it is:

  1. (1)

    a non-directive friendly society; or

  2. (2)

    a Swiss general insurer; or

  3. (3)

    an EEA-deposit insurer; or

  4. (4)

    an incoming EEA firm; or

  5. (5)

    an incoming Treaty firm.

Purpose

PRU 2.3.2G

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.

PRU 2.3.3G

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.

PRU 2.3.4G

There are two main purposes of this section:

  1. (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. (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.

Main requirements and guidance

PRU 2.3.5G

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.

PRU 2.3.6G

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.

PRU 2.3.7G

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.

PRU 2.3.8G

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.

PRU 2.3.9G

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.

PRU 2.3.10R

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

PRU 2.3.11R

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. (1)

    the asset-related capital requirement; and

  2. (2)

    the insurance-related capital requirement; less

  3. (3)

    the firm's equalisation provisions.

PRU 2.3.12G

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.

PRU 2.3.13G

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.

PRU 2.3.14G

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.

PRU 2.3.15G

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).

PRU 2.3.16G

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.

PRU 2.3.17G

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.

Stress and scenario requirement

PRU 2.3.18G

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.

Factors to consider when assessing credit risk

PRU 2.3.19G

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.

PRU 2.3.20G

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

  1. (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. (2)

    the financial effect of non-payment of premium debtors such as intermediaries and policyholders.

PRU 2.3.21G

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

  1. (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. (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. (3)

    a deterioration in the creditworthiness of the firm's reinsurers, intermediaries or other counterparties;

  4. (4)

    the degree of credit concentration. For example, the degree to which a firm is exposed to a single counterparty or group;

  5. (5)

    the degree of concentration of exposure to reinsurers of particular rating grades;

  6. (6)

    the prospect of reinsurance rates increasing substantially or reinsurance being unavailable;

  7. (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. (8)

    greater losses from bad debts than anticipated;

  9. (9)

    deterioration in the extent and quality of collateral; and

  10. (10)

    guarantees given by the insurer of the performance of others, whether under contracts of insurance or otherwise.

Factors to consider when assessing market risk

PRU 2.3.22G

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

PRU 2.3.23G

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

  1. (1)

    reduced market values of investments;

  2. (2)

    variation in interest rates and the effect on the market value of investments;

  3. (3)

    a lower level of investment income than planned; and

  4. (4)

    the possibility of counterparty defaults.

PRU 2.3.24G

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

  1. (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. (2)

    unanticipated losses and defaults of issuers;

  3. (3)

    price shifts in asset classes, and their impact on the entire portfolio;

  4. (4)

    inadequate valuation of assets;

  5. (5)

    the direct impact on the portfolio of currency devaluation, as well as the effect on related markets and currencies;

  6. (6)

    extent of any mismatch of assets and liabilities, including reinvestment risk;

  7. (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. (8)

    the extent to which market moves could have non-linear effects on values, such as derivatives.

Factors to consider when assessing liquidity risk

PRU 2.3.25G

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.

PRU 2.3.26G

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. (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. (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.

PRU 2.3.27G

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.

PRU 2.3.28G

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

  1. (1)

    any mismatching between expected asset and liability cash flows;

  2. (2)

    the inability to sell assets quickly;

  3. (3)

    the extent to which the firm's assets have been pledged;

  4. (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. (5)

    the possible need to reduce large asset positions at different levels of market liquidity, and the related potential costs and timing constraints.

Factors to consider when assessing operational risk

PRU 2.3.29 G

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

PRU 2.3.30G

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

PRU 2.3.31G

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

  1. (1)

    the likelihood of fraudulent activity occurring that may impact upon the financial or operational aspects of the firm;

  2. (2)

    the obligation a firm may have to fund a pension scheme for its employees;

  3. (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. (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. (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. (6)

    the impact of legal risks. For example a non-insurance related legal action being pursued against the firm;

  7. (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. (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.

PRU 2.3.32G

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.

Factors to consider when assessing insurance risk

PRU 2.3.33G

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. (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. (2)

    determine the likelihood of any other feature of insurance risk that may lead to a variation in projected outcomes.

  3. (3)

    Firms carrying on general insurance business should in addition:

    1. (a)

      analyse the potential for claims reserves to deteriorate beyond the current reserving level; and

    2. (b)

      determine the effect of loss ratios being higher than planned by analysing historic loss ratio experience and volatility.

  4. (4)

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

    1. (a)

      analyse the potential for mathematical reserves subsequently to prove inadequate compared with the current reserving level; and

    2. (b)

      determine the effect of claims experience being more costly than planned by analysing historic claims experience, volatility and trends in experience.

PRU 2.3.34G

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

  1. (1)

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

    1. (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;

    2. (b)

      the uncertainty of claims experience;

    3. (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;

    4. (d)

      the appropriateness of policy wordings;

    5. (e)

      the risk of mis-selling, for example, the number of complaints or disputed claims; and

    6. (f)

      the tolerance for expense reserve variations or variations in expenses (including indirect costs).

  2. (2)

    For firms carrying on general insurance business, in addition:

    1. (a)

      the length of tail of the claims development and latent claims; and

    2. (b)

      the effects of rapid growth or decline in the volume of the underwriting portfolio.

  3. (3)

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

    1. (a)

      the uncertainty of future investment returns;

    2. (b)

      the effects of rapid growth or decline in the volume and nature of new business written; and

    3. (c)

      the ability of firms to adjust premium rates or charges for some products.

  4. (4)

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

    1. (a)

      the frequency and size of large claims;

    2. (b)

      possible outcomes relating to any disputed claims, particularly where the outcome is subject to legal proceedings;

    3. (c)

      the ability of the firm to withstand catastrophic events, increases in unexpected exposures, latent claims or aggregation of claims;

    4. (d)

      the possible exhaustion of reinsurance arrangements, both on a per risk and per event basis;

    5. (e)

      social changes regarding an increase in the propensity to claim and to sue; and

    6. (f)

      other social, economic and technological changes.

  5. (5)

    For firms carrying on general insurance business:

    1. (a)

      the adequacy and uncertainty of the technical claims provisions, such as outstanding claims, IBNR and claims handling expense reserves;

    2. (b)

      the adequacy of other underwriting provisions, such as the provisions for unearned premium and unexpired risk reserves;

    3. (c)

      the appropriateness of catastrophe models and underlying assumptions used, such as possible maximum loss (PML) factors used;

    4. (d)

      unanticipated legal judgements and legal change with retrospective effect specifically with regard to the claims reserves; and

    5. (e)

      the effects of inflation.

  6. (6)

    For firms carrying on long-term insurance business:

    1. (a)

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

      1. (i)

        the risk that investment returns differ from those assumed in the reserving assumptions;

      2. (ii)

        the risk of variations in mortality, morbidity and persistency experience and in the exercise of options under contracts;

      3. (iii)

        the rates of taxation applied, in particular where there is uncertainty over the tax treatment; and

    2. (b)

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

Other assessments of the adequacy of capital resources

PRU 2.3.35G

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.

PRU 2.3.36G

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.

PRU 2.3.37G

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.

PRU 2.3.38G

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.

PRU 2.3.39G

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.

PRU 2.3.40G

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.

PRU 2.3.41G

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.

PRU 2.3.42G

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.

PRU 2.3.43G

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.

PRU 2.3.44G

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.

PRU 2.3.45G

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.

PRU 2.3.46G

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.

PRU 2.3.47G

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. (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. (2)

    a failure by the firm's senior management to approve its financial results; and

  3. (3)

    a failure by the firm to consider an analysis of relevant internal and external information on its business and control environment.

PRU 2.3.48G

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.

Capital models

PRU 2.3.49G

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.

PRU 2.3.50G

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.

PRU 2.3.51G

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

  1. (1)

    the extent of use of the internal capital model within the firm's capital management policy;

  2. (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. (3)

    that all material risks to which the firm is exposed have been adequately addressed by quantitative and qualitative means as appropriate;

  4. (4)

    the confidence levels set and whether these are linked to the firm's corporate strategy;

  5. (5)

    the time horizons set for the different types of business that the firm undertakes;

  6. (6)

    the extent of historic data used and back testing carried out; and

  7. (7)

    whether sufficient accuracy and validation in the internal capital model has been undertaken.

Quantitative factors

PRU 2.3.52G

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.

PRU 2.3.53G

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. (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. (2)

    five-year predictions as to premium rates in each homogeneous category of business taking account of the effect of underwriting cycles;

  3. (3)

    predictions of exposures written in each homogeneous category of business in the next five years;

  4. (4)

    predictions of premium volume and expected growth under a five year business plan;

  5. (5)

    expenses and commission;

  6. (6)

    catastrophic events, aggregations of claims and claims affecting more than one class of business;

  7. (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. (8)

    reinsurance programmes in place, allowing for changing term conditions, reinstatements and loss experience features;

  9. (9)

    estimates of non-recovery of reinsurance and other debtors taking account of the financial strength of each reinsurance or other counterparty; and

  10. (10)

    foreign exchange movements.

For firms carrying on general insurance business in particular:

  1. (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;

  2. (12)

    settlement patterns of claims and reinsurance recoveries for each homogeneous category of business (including occurred and future claims);

  3. (13)

    unintended coverage of risks; and

  4. (14)

    correlation between these risks.

For firms carrying on long-term insurance business in particular:

  1. (15)

    projected claims experience for each homogeneous category of business allowing for trends in mortality/ morbidity experience;

  2. (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

  3. (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.

PRU 2.3.54G

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.

PRU 2.3.55G

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.

PRU 2.3.56G

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.