PRU 3.1 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 3.1 applies to:

1. (1)

   an EEA-deposit insurer; and

2. (2)

   a Swiss general insurer;

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

This section provides guidance on how to interpret PRU 1.4 insofar as it relates to the management of credit risk.

Credit risk is incurred whenever a firm is exposed to loss if another party fails to perform its financial obligations to the firm, including failing to perform them in a timely manner. It arises from both on and off balance sheet items. For contracts for traded financial instruments, for example the purchase and sale of securities or over the counter derivatives, risks may arise if the firm's counterparty does not honour its side of the contract. This constitutes counterparty risk, which can be considered a subset of credit risk. Another risk is issuer risk, which could potentially result in a firm losing the full price of a market instrument since default by the issuer could result in the value of its bonds or stocks falling to nil. In insurance firms, credit risk can arise from premium debtors, where cover under contracts of insurance may either commence before premiums become due or continue after their non-payment. Credit risk can also arise if a reinsurer fails to fulfil its financial obligation to repay a firm upon submission of a claim.

Credit risk concerns the FSA in a prudential context because inadequate systems and controls for credit risk management can create a threat to the regulatory objectives of market confidence and consumer protection by:

1. (1)

   the erosion of a firm's capital due to excessive credit losses thereby threatening its viability as a going concern;

2. (2)

   an inability of a firm to meet its own obligations to depositors, policyholders or other market counterparties due to capital erosion.

Appropriate systems and controls for the management of credit risk will vary with the scale, nature and complexity of the firm's activities. Therefore the material in this section is guidance. A firm should assess the appropriateness of any particular item of guidance in the light of the scale, nature and complexity of its activities as well as its obligations as set out in Principle 3 to organise and control its affairs responsibly and effectively.

High level requirements for prudential systems and controls, including those for credit risk, are set out in PRU 1.4. In particular:

1. (1)

   PRU 1.4.19R (2) requires a firm to document its policy for credit risk, including its risk appetite and how it identifies, measures, monitors and controls that risk;

2. (2)

   PRU 1.4.19R (2) requires a firm to document its provisioning policy. Documentation should describe the systems and controls that it intends to use to ensure that the policy is correctly implemented;

3. (3)

   PRU 1.4.18 R requires it to establish and maintain risk management systems to identify, measure, monitor and control credit risk (in accordance with its credit risk policy), and to take reasonable steps to ensure that its systems are adequate for that purpose;

4. (4)

   In line with PRU 1.4.11 G, the ultimate responsibility for the management of credit risk should rest with a firm's governing body. Where delegation of authority occurs the governing body and relevant senior managers should approve and periodically review systems and controls to ensure that delegated duties are being performed correctly.

PRU 1.4.18 R requires a firm to establish, maintain and document a business plan and risk policies. They should provide a clear indication of the amount and nature of credit risk that the firm wishes to incur. In particular, they should cover for credit risk:

1. (1)

   how, with particular reference to its activities, the firm defines and measures credit risk;

2. (2)

   the firm's business aims in incurring credit risk including:

   1. (a)

      identifying the types and sources of credit risk to which the firm wishes to be exposed (and the limits on that exposure) and those to which the firm wishes not to be exposed (and how that is to be achieved, for example how exposure is to be avoided or mitigated);

   2. (b)

      specifying the level of diversification required by the firm and the firm's tolerance for risk concentrations (and the limits on those exposures and concentrations); and

   3. (c)

      drawing the distinction between activities where credit risk is taken in order to achieve a return (for example, lending) and activities where credit exposure arises as a consequence of pursuing some other objective (for example, the purchase of a derivative in order to mitigate market risk);

3. (3)

   how credit risk is assessed both when credit is granted or incurred and subsequently, including how the adequacy of any security and other risk mitigation techniques is assessed;

4. (4)

   the detailed limit structure for credit risk which should:

   1. (a)

      address all key risk factors, including intra-group exposures and indirect exposures (for example, exposures held by related and subsidiary undertakings);

   2. (b)

      be commensurate with the volume and complexity of activity;

   3. (c)

      be consistent with the firm's business aims, historical performance, and its risk appetite;

5. (5)

   procedures for:

   1. (a)

      approving new or additional exposures to counterparties;

   2. (b)

      approving new products and activities that give rise to credit risk;

   3. (c)

      regular risk position and performance reporting;

   4. (d)

      limit exception reporting and approval; and

   5. (e)

      identifying and dealing with problem exposures caused by the failure or the downgrading of a counterparty;

6. (6)

   the methods and assumptions used for the stress testing and scenario analysis required by PRU 1.2 (Adequacy of financial resources), including how these methods and assumptions are selected and tested;

7. (7)

   the allocation of responsibilities for implementing the credit risk policy and for monitoring adherence to, and the effectiveness of, the policy.

The firm should make a suitable assessment of the risk profile of the counterparty. The factors to be considered will vary according to both the type of credit and the counterparty being considered. This may include:

1. (1)

   the purpose of the credit, the duration of the agreement and the source of repayment;

2. (2)

   an assessment and continuous monitoring of the credit quality of the counterparty;

3. (3)

   an assessment of the claims payment record where the counterparty is a reinsurer;

4. (4)

   an assessment of the nature and amount of risk attached to the counterparty in the context of the industrial sector or geographical region or country in which it operates, as well as the potential impact on the counterparty of political, economic and market changes; and

5. (5)

   the proposed terms and conditions attached to the granting of credit, including ongoing provision of information by the counterparty, covenants attached to the facility as well as the adequacy and enforceability of collateral, security and guarantees.

It is important that sound and legally enforceable documentation is in place for each agreement that gives rise to credit risk as this may be called upon in the event of a default or dispute. A firm should therefore consider whether it is appropriate for an independent legal opinion to be sought on documentation used by the firm. Documentation should normally be in place before the firm enters into a contractual obligation or releases funds.

Where premium payments are made via brokers or intermediaries, the firm should describe how it monitors and controls its exposure to those brokers and intermediaries. In particular, the policy should identify whether the risk of default by the broker or intermediary is borne by the firm or the policyholder.

Any variation from the usual credit policy should be documented.

A firm involved in loan syndications or consortia should not rely on other parties' assessment of the credit risks involved. It will remain responsible for forming its own judgement on the appropriateness of the credit risk thereby incurred with reference to its stated credit risk policy. Similarly a firm remains responsible for assessing the credit risk associated with any insurance or reinsurance placed on its behalf by other parties.

Where a credit scoring approach or other counterparty assessment process is used, the firm should periodically assess the particular approach taken in the light of past and expected future counterparty performance and ensure that any statistical process is adjusted accordingly to ensure that the business written complies with the firm's risk appetite.

In assessing its contingent exposure to a counterparty, the firm should identify the amount which would be due from the counterparty if the value, index or other factor upon which that amount depends were to change.

A firm should measure its credit risk using a robust and consistent methodology which should be described in its credit risk policy; the appropriate method of measurement will depend upon the nature of the credit product provided. The firm should consider whether the measurement methodologies should be backtested and the frequency of such backtesting.

A firm should also be able to measure its credit exposure across its entire portfolio or within particular categories such as exposures to particular industries, economic sectors or geographical areas.

Where a firm is a member of a group that is subject to consolidated reporting, the group should be able to monitor credit exposures on a consolidated basis. See PRU 8 (Group risk).

A firm should have the capability to measure its credit exposure to individual counterparties on at least a daily basis.

A firm should implement an effective system for monitoring its credit risk which should be described in its credit risk policy.

A firm should have a system of management reporting which provides clear, concise, timely and accurate credit risk reports to relevant functions within the firm. The reports could cover exceptions to the firm's credit risk policy, non-performing exposures and changes to the level of credit risk within the firm's credit portfolio. A firm should have procedures for taking appropriate action according to the information within the management reports, such as a review of counterparty limits, or of the overall credit policy.

Individual credit facilities and overall limits should be periodically reviewed in order to check their appropriateness for both the current circumstances of the counterparty and the firm's current internal and external economic environment. The frequency of review should be appropriate to the nature of the facility.

A firm should utilise appropriate stress testing and scenario analysis of credit exposures to examine the potential effects of economic or industry downturns, market events, changes in interest rates, changes in foreign exchange rates, changes in liquidity conditions and changes in levels of insurance losses where relevant.

A firm should have systematic processes for the timely identification, management and monitoring of problem exposures. These processes should be described in the credit risk policy.

A firm should have adequate procedures for recovering exposures in arrears or that have had provisions made against them. A firm should allocate responsibility, either internally or externally, for its arrears management and recovery.

PRU 1.4.19R (2) requires a firm to document its provisioning policy. A firm's provisioning policy can be maintained either as a separate document or as part of its credit risk policy.

At intervals that are appropriate to the nature, scale and complexity of its activities a firm should review and update its provisioning policy and associated systems.

In line with PRU 3.1.6 G, the FSA recognises that the frequency with which a firm reviews its provisioning policy once it has been established will vary from firm to firm. However, the FSA expects a firm to review at least annually whether its policy remains appropriate for the business it undertakes and the economic environment in which it operates.

In line with PRU 1.4.12 G, the provisioning policy referred to in PRU 3.1.26 G must be approved by the firm's governing body or another appropriate body to which the firm's governing body has delegated this responsibility.

In line with PRU 1.4.24 G, the FSA may request a firm to provide it with a copy of its current provisioning policy.

Provisions may be general (against the whole of a given portfolio), specific (against particular exposures identified as bad or doubtful) or both. The FSA expects contingent liabilities (for example guarantees) and anticipated losses to be recognised in accordance with accepted accounting standards at the relevant time, such as those embodied in the Financial Reporting Standards issued by the Accounting Standards Board.

A firm may choose to use various credit risk mitigation techniques including the taking of collateral, the use of letters of credit or guarantees, or counterparty netting agreements to manage and control their counterparty exposures. The use of such techniques does not obviate the need for thorough credit analysis and procedures. The reliance placed by a firm on risk mitigation should be described in the credit risk policy.

A firm should consider the legal and financial ability of a guarantor to fulfil the guarantee if called upon to do so.

A firm should monitor the validity and enforceability of its collateral arrangements.

The firm should analyse carefully the protection afforded by risk mitigants such as netting agreements or credit derivatives, to ensure that any residual risk is identified, measured, monitored and controlled.

Prudential records made under PRU 1.4.53 R should include appropriate records of:

1. (1)

   credit exposures, including aggregations of credit exposures, as appropriate, by:

   1. (a)

      groups of connected counterparties;

   2. (b)

      types of counterparty as defined, for example, by the nature or geographical location of the counterparty;

2. (2)

   credit decisions, including details of the decision and the facts or circumstances upon which it was made; and

3. (3)

   information relevant to assessing current counterparty and risk quality.

Credit records should be retained as long as they are needed for the purpose described in PRU 3.1.36 G (subject to the minimum three year retention period). In particular, a firm should consider whether it is appropriate to retain information regarding counterparty history such as a record of credit events as well as a record indicating how credit decisions were taken.

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.

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.

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.

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.

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.

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.

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

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

The scope of application of PRU 3.3 is not restricted to firms that are subject to the relevant EC directives. It applies, for example, to pure reinsurers.

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.

The requirements in PRU 3.3 apply to a firm on a solo basis.

PRU 2.1.9 R requires that a firm must maintain at all times capital resources equal to or in excess of its capital resources requirement. PRU 2.1.14 R provides that for a firm carrying on general insurance business the firm's capital resources requirement is the Minimum Capital Requirement.

The FSA will use the Enhanced Capital Requirement as the benchmark for individual capital guidance for a firm carrying on general insurance business, other than a non-directive insurer. The Enhanced Capital Requirement is the sum of the asset-related capital requirement and the insurance-related capital requirement less the firm's equalisation provisions. This section sets out rules and guidance relating to the asset-related capital requirement. Rules and guidance relating to the insurance-related capital requirement are set out in PRU 7.2.

The asset-related capital requirement is a measure of the capital that a firm should hold against the risk of loss if another party fails to perform its financial obligations to the firm or from adverse movements in the value of assets.

The asset-related capital requirement is calculated by applying capital charge factors, expressed as a percentage, to different categories of a firm's assets. A firm should refer to PRU 1.3 which sets out how a firm must recognise and value assets and liabilities.

Options: some derivatives may allow a firm an option whether to buy or sell a particular asset. If an option has a positive market value (that is, in-the-money) it is likely that the firm will exercise the option in the future and the current value of the derivative and associated asset will generally acquire new characteristics and volatility (a 'synthetic asset'). For instance, an option to acquire shares at a price below their current market value is likely to be exercised and the appropriate asset-related capital requirement calculation would be to combine the cash cost of acquiring the number of shares covered by the option with the value of the derivative and apply a factor of 16% to that combined value. If an option has no market value (that is, out-of-the-money) then it is unlikely that a firm would exercise the option in which case the appropriate asset-related capital requirement charge would be zero in respect of the derivative, and the corresponding capital charge contained in Table PRU 3.3.16 R in relation to the asset associated with the derivative.

Futures and swaps: futures or swaps may not allow the firm such an option in which case the appropriate asset-related capital charge factor to apply is the one corresponding to the asset that would be held on fulfilment of the contract and the value to which this should be applied would be the value of the asset held after the contract is fulfilled.