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PRU 3.2 Credit risk in insurance

Application

PRU 3.2.1R

PRU 3.2 applies to an insurer unless it is:

  1. (1)

    a non-directive friendly society; or

  2. (2)

    an incoming EEA firm; or

  3. (3)

    an incoming Treaty firm.

PRU 3.2.2R

All of PRU 3.2, except PRU 3.2.20 R and PRU 3.2.23 R to PRU 3.2.32 G, applies to:

  1. (1)

    an EEA-deposit insurer; and

  2. (2)

    a Swiss general insurer;

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

PRU 3.2.3G

The scope of application of PRU 3.2 is not restricted to firms that are subject to relevant EC directives. It applies, for example, to pure reinsurers.

PRU 3.2.4R

  1. (1)

    This section applies to a firm in relation to the whole of its business, except where a particular provision provides for a narrower scope.

  2. (2)

    Where a firm carries on both long-term insurance business and general insurance business, this section applies separately to each type of business.

Purpose

PRU 3.2.5G

The purpose of this section is to protect policyholders and potential policyholders by setting out the requirements applicable to a firm in respect of credit risk. Credit risk is incurred whenever a firm is exposed to loss if a counterparty fails to perform its contractual obligations including failure to perform them in a timely manner. Credit risk may therefore have an impact upon a firm's ability to meet its valid claims as they fall due. Credit risk can also arise from underlying causes that have an impact upon the creditworthiness of all counterparties of a particular description or geographical location. A detailed explanation of credit risk is given at PRU 3.1.4 G.

PRU 3.2.6G

The requirements in this section address both current and contingent exposure to credit risk. PRIN, SYSC and PRU 1.4 require a firm to establish adequate internal systems and controls for exposure to credit risk. This section requires a firm to restrict its exposure to different counterparties and assets to prudent levels and to ensure that those exposures are adequately diversified. It also requires a firm to make deductions from the value of assets in respect of exposures to one asset, counterparty or group of closely related counterparties in excess of prescribed limits.

PRU 3.2.7G

This section also sets limits on the market risk arising from holding assets including securities issued or guaranteed by counterparties. This market risk is incurred whenever a firm is exposed to loss if an asset were to reduce in value or even become worthless. These market risk limits are set out in this section rather than the market risk sections in PRU because they are closely linked to the counterparty limits set out in this section.

Overall limitation of credit risk

PRU 3.2.8R

Taking into account relevant risks, a firm must restrict its counterparty exposures and asset exposures to prudent levels and ensure that those exposures are adequately diversified.

PRU 3.2.9R

  1. (1)

    For the purposes of PRU 3.2, counterparty exposure is the amount a firm would lose if a counterparty were to fail to meet its obligations (either to the firm or to any other person) and if simultaneously securities issued or guaranteed by the counterparty were to become worthless.

  2. (2)

    For the purposes of PRU 3.2, asset exposure is the amount a firm would lose if an asset or class of identical assets (whether or not held directly by the firm) were to become worthless.

  3. (3)

    For the purposes of (1) and (2), the amount of loss is the amount, if any, by which the firm's capital resources (as calculated in accordance with PRU 2.2.14 R but without making any deduction for assets in excess of market risk and counterparty limits) would decrease as a result of the counterparty failing to meet its obligations and the securities or assets becoming worthless.

  4. (4)

    In determining the amount of loss in accordance with (3), the firm must take into account decreases in its capital resources that would result not only from its own direct exposures but also from:

    1. (a)

      exposures held by any of its subsidiary undertakings; and

    2. (b)

      synthetic exposures arising from derivatives or quasi-derivatives held or entered into by the firm or any of its subsidiary undertakings.

  5. (5)

    If a firm elects under PRU 3.2.35 R to make a deduction in respect of collateral, the firm must deduct from the amount of loss determined in accordance with (3) so much of the value of that collateral as:

    1. (a)

      would be realised by the firm were it to exercise its rights in relation to the collateral; and

    2. (b)

      does not exceed any of the relevant limits in PRU 3.2.22R (3).

PRU 3.2.10G

Exposure is defined in terms of loss (which is decrease in capital). It does not include exposures arising from assets that are not represented in capital or exposures which if crystallised in a loss would be offset by a consequent gain, reduction in liabilities or release of provisions, but only in so far as that gain, reduction or release would itself lead to an offsetting increase in capital resources. Examples include:

  1. (1)

    exposure from the holding of assets to which the firm has attributed no value;

  2. (2)

    exposure from the holding of assets that the firm has deducted from capital resources; and

  3. (3)

    exposure in respect of which (and to the extent that) the firm has established a provision.

PRU 3.2.11G

In assessing the adequacy of diversification required by PRU 3.2.8 R, a firm should take into account concentrations of exposure including those arising from:

  1. (1)

    different types of exposure to the same counterparty, such as deposits, loans, securities, reinsurance and derivatives;

  2. (2)

    links between counterparties such that default by one might have an impact upon the creditworthiness of another; and

  3. (3)

    possible changes in circumstance that would have an impact upon the creditworthiness of all counterparties of particular description or geographical location.

PRU 3.2.12G

A firm should consider how the spreading of credit risk will impact on overall counterparty quality.

PRU 3.2.13G

In assessing its exposure to a counterparty for the purpose of PRU 3.2.8 R, a firm should take into account:

  1. (1)

    the period for which the exposure to that counterparty might continue;

  2. (2)

    the likelihood of default during that period by the counterparty; and

  3. (3)

    the loss that might result in the event of default.

PRU 3.2.14G

In assessing the loss that might result from the default of a counterparty for the purposes of PRU 3.2.8 R, a firm should take into account the circumstances that might lead to default and, in particular, how these might have an impact upon:

  1. (1)

    the amount of exposure to the counterparty; and

  2. (2)

    the effectiveness of any loss mitigation techniques employed by the firm.

PRU 3.2.15G

Often the same circumstances which lead to the crystallisation of contingent credit exposure, e.g. a significant claims event or a significant movement in interest, currency or asset values, also lead to an increase in the risk of default by the counterparty. In particular, if a reinsurer or derivative counterparty is being relied upon to provide protection against the consequences of an event or circumstance, a firm should take into account how that event or circumstance might have an impact upon the creditworthiness of the reinsurer or derivative counterparty.

PRU 3.2.16R

For the purposes of PRU 3.2.8 R and of determining counterparty exposure and asset exposure in accordance with PRU 3.2.9 R and reinsurance exposure in accordance with PRU 3.2.25 R, a firm must only rely upon a loss mitigation technique where it has good reason to believe that, taking into account the possible circumstances of default, it is likely to be effective.

PRU 3.2.17G

Loss mitigation techniques include:

  1. (1)

    the right, upon default, to preferential access to some or all of the counterparty's assets, for example by exercising rights of set off, holding collateral or assets deposited back, or exercising rights under fixed or floating charges;

  2. (2)

    rights against third parties upon default by the counterparty, such as guarantees, credit insurance and credit derivatives; and

  3. (3)

    where the counterparty is a reinsurer, having back-up or flexible reinsurance which covers the gap in coverage left by the reinsurer's default, for example 'top and drop' reinsurance.

PRU 3.2.18R

For the purposes of PRU 3.2.8 R and of determining counterparty exposure and asset exposure in accordance with PRU 3.2.9 R and reinsurance exposure in accordance with PRU 3.2.25 R, a firm must not rely upon preferential access to assets unless it has taken into account appropriate professional advice as to its effectiveness.

PRU 3.2.19G

In particular, a firm should consider whether any preferential access to a counterparty's assets would be effective even if the counterparty were wound up by a court or other legal process or it were to be subject to any other insolvency process. A firm should also consider, where it is relying upon a right against a third party, whether, in the circumstances of the counterparty's default, the creditworthiness of that third party might be impaired.

Large exposure limits

PRU 3.2.20R

  1. (1)

    A firm must take reasonable steps to limit its counterparty exposure or asset exposure to:

    1. (a)

      a single counterparty;

    2. (b)

      each of the counterparties within a group of closely related counterparties; and

    3. (c)

      an asset or class of identical assets;

    to a level where, if a total default were to occur, the firm would not become unable to meet its liabilities as they fall due.

  2. (2)

    In (1), a total default occurs where:

    1. (a)

      the single counterparty or all of the counterparties within the group of closely related counterparties fail to meet its or their obligations and simultaneously any securities issued or guaranteed by it or any of them become worthless; or

    2. (b)

      the asset becomes worthless or all of the assets within the identical class become worthless at the same time.

  3. (3)

    (1) does not apply to:

    1. (a)

      a reinsurance exposure; or

    2. (b)

      a counterparty exposure or asset exposure to an approved credit institution.

PRU 3.2.21G

In assessing its exposure to a counterparty or group of closely related counterparties, a firm should consider exposures from different sources including deposits, loans, securities and derivatives.

Market risk and counterparty limits

PRU 3.2.22R

  1. (1)

    A firm must calculate the amount of the deduction from total capital required by stage L in the Table in PRU 2.2.14 R in respect of assets in excess of market risk and counterparty limits as the aggregate amount by which its counterparty exposures and asset exposures exceed the relevant limits set out in (3).

  2. (2)

    Except where the contrary is expressly stated in PRU, whenever:

    1. (a)

      a rule in PRU refers to assets of a firm, or of any part of a firm, or of any fund or part of a fund within a firm, which are assets of a kind referred to in any of the limits in (3); and

    2. (b)

      the firm's counterparty exposure (or aggregate exposure arising from the counterparty exposures to each member of a group of closely related persons) or asset exposure in respect of those assets exceeds any of the limits in (3);

the firm must deduct from the measure of the value of those assets (as determined in accordance with PRU 1.3) the amount by which that exposure exceeds the relevant limit in (3), or that portion of the deduction that relates to the part of the firm or fund or part of a fund in question.

  1. (3)

    The limits referred to in (1) and (2) are the following, expressed as a percentage of the firm's business amount:

    1. (a)

      for a counterparty exposure to an individual, unincorporated body of individuals or the aggregate exposure arising from the counterparty exposures to each member of a group of closely related individuals or unincorporated bodies of individuals:

      1. (i)

        ¼% for that part of the exposure that arises from unsecured debt;

      2. (ii)

        1% for the whole exposure (after deduction of the excess arising from the limit in (a)(i));

    2. (b)

      for a counterparty exposure to an approved counterparty or the aggregate exposure arising from the counterparty exposures to each member of a group of closely related approved counterparties:

      1. (i)

        5% for that part of the exposure not arising from short term deposits made with an approved credit institution; this limit is increased to 10% if the total of such exposures which exceed 5% is less than 40%;

      2. (ii)

        20% or £2 million if larger for the whole exposure (after deduction of the excess arising from the limit in (b)(i));

    3. (c)

      for a counterparty exposure to a person, or the aggregate exposure arising from the counterparty exposures to each member of a group of closely related persons, who do not fall into the categories of counterparty to whom (a) and (b) apply:

      1. (i)

        1% for that part of the exposure arising from unsecured debt; this limit is increased to 2.5% in the case of an exposure to a regulated institution;

      2. (ii)

        1% for that part of the exposure arising from shares, bonds, debt securities and other money market instruments and capital market instruments from the same counterparty that are not dealt in on a regulated market, or any beneficial interest in a collective investment scheme which is not a UCITS scheme, a non-UCITS retail scheme or a recognised scheme; the limit for that part of the exposure arising from debt securities (other than hybrid securities) issued by the same regulated institution is increased to 5%;

      3. (iii)

        5% for the whole exposure (after deduction of the excesses arising from the limits in (c)(i) and (ii));

    4. (d)

      5% for the aggregate of all counterparty exposures that fall within (c)(i) whether or not they arise from persons who are closely related, but excluding amounts that are in excess of the limit in (c)(i);

    5. (e)

      10% for the aggregate of all counterparty exposures that fall within (c)(ii) whether or not they arise from persons who are closely related, but excluding amounts that are in excess of the limit in (c)(ii);

    6. (f)

      5% for the aggregate of all counterparty exposures arising from unsecured loans, other than those falling within (3)(b);

    7. (g)

      3% for the asset exposure arising from all cash in hand;

    8. (h)

      10% for the asset exposure (including an exposure arising from a reversionary interest) arising from any one piece of land or building, or a number of pieces of land or buildings close enough to each other to be considered effectively as one investment.

  2. (4)

    In (3) a firm's business amount means the sum of:

    1. (a)

      the firm's total gross technical provisions;

    2. (b)

      the amount of its other liabilities (except those included in the calculation of capital resources in accordance with PRU 2.2.14 R); and

    3. (c)

      such amount as the firm may select not exceeding the amount of the firm's total capital after deductions as calculated at stage M of the calculation in PRU 2.2.14 R or, if higher:

      1. (i)

        in the case of a firm carrying on general insurance business, the amount of its general insurance capital requirement; and

      2. (ii)

        in the case of a firm carrying on long-term insurance business, the amount of its long-term insurance capital requirement and the amount of its resilience capital requirement.

  3. (5)

    For the purpose of (4)(a), a firm's total gross technical provisions exclude technical provisions in respect of index-linked liabilities or property-linked liabilities, except that where the linked long-term contract of insurance in question includes a guarantee of investment performance or some other guaranteed benefit, the total gross technical provisions include the technical provisions in respect of that guaranteed element.

  4. (6)

    In (3)(c)(ii) hybrid security means a debt security, other than an approved security, the terms of which provide, or have the effect that, the holder does not, or would not, have an unconditional entitlement to payment of interest and repayment of capital in full within 75 years of the date on which the security is being valued.

Large exposure calculation for reinsurance exposures

PRU 3.2.23R

A firm must notify the FSA in accordance with SUP 15.7 as soon as it first becomes aware that:

  1. (1)

    a reinsurance exposure to a reinsurer or group of closely related reinsurers is reasonably likely to exceed 100% of its capital resources, excluding capital resources held to cover property-linked liabilities; or

  2. (2)

    if (1) does not apply, that it has exceeded this limit.

PRU 3.2.24R

Upon notification under PRU 3.2.23 R, a firm must:

  1. (1)

    demonstrate that prudent provision has been made for the reinsurance exposure in excess of the 100% limit, or explain why in the opinion of the firm no provision is required; and

  2. (2)

    explain how the reinsurance exposure is being safely managed.

PRU 3.2.25R
  1. (1)

    For the purposes of PRU 3.2, a reinsurance exposure is the amount of loss which a firm would suffer if a reinsurer or group of closely related reinsurers were to fail to meet its or their obligations under contracts of reinsurance reinsuring any of the firm's contracts of insurance.

  2. (2)

    For the purposes of (1), the amount of loss is the amount, if any, by which the firm's capital resources (as calculated in accordance with PRU 2.2.14 R but without making any deduction for assets in excess of market risk and counterparty limits) would decrease as a result of the reinsurer or group of closely related reinsurers failing to meet its or their obligations under the contracts of reinsurance.

  3. (3)

    If a firm elects under PRU 3.2.35 R to make a deduction in respect of collateral, the firm must deduct from the amount of loss determined in accordance with (2) so much of the value of that collateral as:

    1. (a)

      would be realised by the firm were it to exercise its rights in relation to the collateral; and

    2. (b)

      does not exceed any of the relevant limits in PRU 3.2.22R (3).

PRU 3.2.26R

A firm must, in determining its reinsurance exposures for the purposes of PRU 3.2, aggregate any reinsurance exposure where the identity of the reinsurer is not known by the firm with the highest reinsurance exposure where it does know the identity of the reinsurer.

PRU 3.2.27G

PRU 3.2.8 R provides that, taking into account relevant risks, a firm must restrict to prudent levels, and adequately diversify, its exposure to counterparties.

PRU 3.2.28E

  1. (1)

    In each financial year, a firm should restrict the gross earned premiums which it pays to a reinsurer or group of closely related reinsurers to the higher of:

    1. (a)

      20% of the firm's projected gross earned premiums for that financial year; or

    2. (b)

      £4 million.

  2. (2)

    Compliance with this provision may be relied upon as tending to establish compliance with PRU 3.2.8 R.

PRU 3.2.29R

A firm must notify the FSA immediately in accordance with SUP 15.7 if it has exceeded, or anticipates exceeding, the limit expressed in PRU 3.2.28 E.

PRU 3.2.30R

Upon notification under PRU 3.2.29 R, a firm must explain to the FSA how, despite the excess reinsurance concentration, the credit risk is being safely managed.

PRU 3.2.31G

For the purposes of PRU 3.2.24 R and PRU 3.2.30 R, a firm's explanation of how a reinsurance exposure is being safely managed should also describe the reinsurance market in which the exposure has occurred, and the nature of the reinsurance contract. If appropriate, the firm should also provide a detailed plan and timetable explaining how the excess exposure will be reduced to an acceptable level. The explanation should be approved by a person at the firm of appropriate seniority.

PRU 3.2.32G

Where a firm can demonstrate that the arrangement does not give rise to unacceptable levels of credit risk it is unlikely that further action will be required.

Exposures excluded from limits

PRU 3.2.33R

In PRU 3.2.20 R and PRU 3.2.22 R, references to a counterparty exposure or an asset exposure do not include such an exposure arising from:

  1. (1)

    a debt which is fully secured on assets whose value at least equals the amount of the debt;

  2. (2)

    premium debts;

  3. (3)

    advances secured on, and not exceeding the surrender value of, long-term insurance contracts of the firm;

  4. (4)

    rights of salvage or subrogation;

  5. (5)

    deferred acquisition costs;

  6. (6)

    assets held to cover index-linked liabilities or property-linked liabilities, except that where the linked long-term contract of insurance in question includes a guarantee of investment performance or some other guaranteed benefit, PRU 3.2.20 R and PRU 3.2.22 R will nevertheless apply to assets held to cover that guaranteed element;

  7. (7)

    moneys due from, or guaranteed by, a Zone A country;

  8. (8)

    an approved security;

  9. (9)

    a holding in a UCITS scheme.

PRU 3.2.34R

In PRU 3.2.22 R references to a counterparty exposure or an asset exposure do not include such an exposure arising from reinsurance debts and the reinsurer's share of technical provisions.

PRU 3.2.35R

If:

  1. (1)

    a firm has a counterparty exposure, an asset exposure or a reinsurance exposure in respect of which it has rights over collateral; and

  2. (2)

    the assets constituting that collateral would, if owned by the firm, be admissible assets;

the firm may, in determining the amount of that exposure, deduct the value of that collateral in accordance with PRU 3.2.9R (5) or, in the case of a reinsurance exposure, PRU 3.2.25R (3).

PRU 3.2.36R

If a firm has a counterparty exposure, asset exposure or reinsurance exposure the whole or any part of which is:

  1. (1)

    guaranteed by a credit institution or an investment firm subject in either case to the Capital Adequacy Directive or supervision by a third country (non-EEA) supervisory authority with a Capital Adequacy Directive-equivalent regime; or

  2. (2)

    adequately mitigated by a credit derivative;

the firm may, for the purposes of PRU 3.2.20 R, PRU 3.2.22 R and PRU 3.2.23 R, treat that exposure, or that part of the exposure which is so guaranteed or mitigated, as an exposure to the guarantor or derivative counterparty, rather than to the original counterparty, asset or reinsurer.

PRU 3.2.37R

For the purposes of PRU 3.2.36 R, references to an exposure being guaranteed include an exposure secured by a letter of credit, but to fall within PRU 3.2.36 R the guarantee or letter of credit must be direct, explicit, unconditional and irrevocable.

PRU 3.2.38G

The portion of exposure which is guaranteed or mitigated by a credit derivative is itself, as an exposure to the guarantor or derivative counterparty, subject to the limits in PRU 3.2.20 R and PRU 3.2.22 R.

PRU 3.2.39R

For the purposes of PRU 3.2.20 R and PRU 3.2.22 R, a UCITS scheme, a non-UCITS retail scheme, a recognised scheme or any other collective investment scheme that invests only in admissible assets (including any derivatives or quasi-derivatives held by the scheme) is to be treated as closely related to the issuer of the units in that scheme.

Meaning of closely related

PRU 3.2.40R

For the purposes of PRU 3.2, a group of persons is closely related if it consists solely of two or more natural or legal persons who, unless it is shown otherwise, constitute a single risk because as between any two of them one or other of the following relationships apply:

  1. (1)

    one of them, directly or indirectly, has control, as defined in PRU 3.2.41 R, over the other or they are both controlled by the same third party; or

  2. (2)

    there is no relationship of control as defined in PRU 3.2.41 R but they are to be regarded as constituting a single risk because they are so interconnected that, if one of them were to experience financial problems, the other would be likely to encounter repayment difficulties.

PRU 3.2.41R

For the purposes of PRU 3.2.40 R, control means the relationship between a parent undertaking and a subsidiary undertaking, as defined in Article 1 of the Consolidated Accounts Directive (83/349/EEC), or a similar relationship between any natural or legal person and an undertaking.