PRU 4.1 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 4.1 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.

Firms should also see PRU 1.2 (PRU 1.2.40 G to PRU 1.2.55 G) and PRU 4.2.

1. (1)

   The purpose of this section is to amplify PRU 1.4 insofar as it relates to market risk.

2. (2)

   Market risk includes equity, interest rate, FX, commodity risk and interest rate risk on long-term insurance contracts. The price of financial instruments may also be influenced by other risks such as spread risk, basis risk, correlation, specific risk and volatility risk.

3. (3)

   This section does not deal with the risk management of market risk in a group context. A firm that is a member of a group should also read PRU 8.1 (Group risk systems and controls) which outlines the FSA's requirements for the risk management of market risk within a group.

4. (4)

   Appropriate systems and controls for the management of market 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 market 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 market risk, including its risk appetite and how it identifies, measures, monitors and controls that risk;

2. (2)

   PRU 1.4.19R (4) requires a firm to document its asset and liability recognition policy. Documentation should describe the systems and controls that it intends to use to comply with the policy;

3. (3)

   PRU 1.4.19 R requires a firm to establish and maintain risk management systems to identify, measure, monitor and control market risk (in accordance with its market risk policy), and to take reasonable steps to establish systems adequate for that purpose;

4. (4)

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

PRU 1.4 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 market risk that the firm wishes to incur. In particular, they should cover for market risk:

1. (1)

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

2. (2)

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

   1. (a)

      identifying the types and sources of market 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); and

   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).

The market risk policy of a firm should be endorsed by the firm's governing body and implemented by its senior management, who should take adequate steps to disseminate the policy and train the relevant staff such that they can effectively implement the policy.

The market risk policy of a firm should enforce the risk management and control principles and include detailed information on:

1. (1)

   the financial instruments, commodities, assets and liabilities (and mismatches between assets and liabilities) that a firm is exposed to and the limits on those exposures;

2. (2)

   the firm's investment strategy as applicable between each insurance fund;

3. (3)

   activities that are intended to hedge or mitigate market risk including mismatches caused by for example differences in the assets and liabilities and maturity mismatches; and

4. (4)

   the methods and assumptions used for measuring linear, non-linear and geared market risk including the rationale for selection, ongoing validation and testing. Methods might include stress testing and scenario analysis, option Greeks, asset/liability analysis, correlation analysis and Value-at-Risk (VaR). Exposure to non-linear or geared market risk is typically through the use of derivatives.

A firm should have in place appropriate risk reporting systems that enable it to identify the types and amount of market risk to which it is, and potentially could be, exposed. The information that systems should capture may include but is not limited to:

1. (1)

   position information which may include a description of individual financial instruments and their cash flows; and

2. (2)

   market data which may consist of raw time series of market rates, index levels and prices and derived time series of benchmark yield curves, spreads, implied volatilities, historical volatilities and correlations.

Having identified the market risk that the firm is exposed to on at least a daily basis, a firm should be able to measure and manage that market risk on a consistent basis. This may be achieved by:

1. (1)

   regularly stress testing all or parts of the firm's portfolio to estimate potential economic losses in a range of market conditions including abnormal markets. Corporate level stress test results should be discussed regularly by risk monitors, senior management and risk takers, and should guide the firm's market risk appetite (for example, stress tests may lead to discussions on how best to unwind or hedge a position), and influence the internal capital allocation process;

2. (2)

   measuring the firm's exposure to particular categories of market risk (for example, equity, interest rate, foreign exchange and commodities) as well as across its entire portfolio of market risks;

3. (3)

   analysing the impact that new transactions or businesses may have on its market risk position on an on-going basis; and

4. (4)

   regularly backtesting realised results against internal model generated market risk measures in order to evaluate and assess its accuracy. For example, a firm should keep a database of daily risk measures such as VaR and option Greeks, and use these to back test predicted profit and loss against actual profit and loss for all trading desks and business units, and monitor the number of exceptions from agreed confidence bands.

A firm should take reasonable steps to establish systems and control procedures such that the firm complies with the requirements of PRU 1.3 (Valuation).

The systems and controls referred to in PRU 4.1.11 G should include the following:

1. (1)

   the department responsible for the validation of the value of assets and liabilities should be independent of the business trading area, and should be adequately resourced by suitably qualified staff. The department should report to a suitably qualified individual, independent from the business trading area, who has sufficient authority to enforce the systems and controls policies and any alterations to valuation treatments where necessary;

2. (2)

   all valuations should be checked and validated at appropriate intervals. Where a firm has chosen not to validate all valuations on a daily basis this should be agreed by senior management;

3. (3)

   a firm should establish a review procedure to check that the valuation procedures are followed and are producing valuations in compliance with the requirements in this section. The review should be undertaken by suitably qualified staff independent of the business trading area, on a regular and ad hoc basis. In particular, this review procedure should include:

   1. (a)

      the quality and appropriateness of the price sources used;

   2. (b)

      valuation reserves held; and

   3. (c)

      the valuation methodology employed for each product and consistent adherence to that methodology;

4. (4)

   where a valuation is disputed and the dispute cannot be resolved in a timely manner it should be reported to senior management. It should continue to be reported to senior management until agreement is reached;

5. (5)

   where a firm is marking positions to market it should take reasonable steps to establish a price source that is reliable and appropriate to enable compliance with the provisions in this section on an ongoing basis;

6. (6)

   a firm should document its policies and procedures relating to the entire valuation process. In particular, the following should be documented:

   1. (a)

      the valuation methodologies employed for all product categories;

   2. (b)

      details of the price sources used for each product;

   3. (c)

      the procedures to be followed where a valuation is disputed;

   4. (d)

      the valuation adjustment and reserving policies;

   5. (e)

      the level at which a difference between a valuation assigned to an asset or liability and the valuation used for validation purposes will be reported on an exceptions basis and investigated;

   6. (f)

      where a firm is using its own internal estimate to produce a valuation, it should document in detail the process followed in order to produce the valuation; and

   7. (g)

      the review procedures established by a firm in relation to the requirements of this section should be adequately documented and include the rationale for the policy;

7. (7)

   a firm should maintain records which demonstrate:

   1. (a)

      senior management's approval of the policies and procedures established; and

   2. (b)

      management sign-off of the reviews undertaken in accordance with PRU 4.1.11 G.

Risk monitoring is the operational process by which a firm monitors compliance with defined policies and procedures of the market risk policy. The firm's risk monitoring system should be independent of the employees who are responsible for exposing the firm to market risk.

The market risk policy of a firm may require the production of market risk reports at various levels within the firm. These reports should provide sufficiently accurate market risk data to relevant functions within the firm, and should be timely enough to allow any appropriate remedial action to be proposed and taken, for example:

1. (1)

   at firm wide level, a market risk report may include information:

   1. (a)

      summarising and commenting on the total market risk that a firm is exposed to and market risk concentrations by business unit, asset class and country;

   2. (b)

      on VaR reports against risk limits by business unit, asset class and country;

   3. (c)

      commenting on significant risk concentrations and market developments; and

   4. (d)

      on market risk in particular legal entities and geographical regions;

2. (2)

   at the business unit level, a market risk report may include information summarising market risk by currency, trading desk, maturity or duration band, or by instrument type;

3. (3)

   at the trading desk level, a market risk report may include detailed information summarising market risk by individual trader, instrument, position, currency, or maturity or duration band; and

4. (4)

   all risk data should be readily reconcilable back to the prime books of entry with a fully documented audit trail.

Risk monitoring may also include information on:

1. (1)

   the procedures for taking appropriate action in response to the information within the market risk reports;

2. (2)

   ensuring that there are controls and procedures for identifying and reporting trades and positions booked at off-market rates;

3. (3)

   the process for new product approvals;

4. (4)

   the process for dealing with situations (authorised and unauthorised) where particular market risk exposures exceed predetermined risk limits and criteria; and

5. (5)

   the periodic review of the risk monitoring process in order to check its suitability for both current market conditions and the firm's overall risk appetite.

Risk monitoring should be subject to periodic independent review by suitably qualified staff.

Risk control is the independent monitoring, assessment and supervision of business units within the defined policies and procedures of the market risk policy. This may be achieved by:

1. (1)

   setting an appropriate market risk limit structure to control the firm's exposure to market risk; for example, by setting out a detailed market risk limit structure at the corporate level, the business unit level and the trading desk level which addresses all the key market risk factors and is commensurate with the volume and complexity of activity that the firm undertakes;

2. (2)

   setting limits on risks such as price or rate risk, as well as those factors arising from options such as delta, gamma, vega, rho and theta;

3. (3)

   setting limits on net and gross positions, market risk concentrations, the maximum allowable loss (also called "stop-loss"), VaR, potential risks arising from stress testing and scenario analysis, gap analysis, correlation, liquidity and volatility; and

4. (4)

   considering whether it is appropriate to set intermediate (early warning) thresholds that alert management when limits are being approached, triggering review and action where appropriate.

High level requirements for record keeping are set out in PRU 1.4.

In relation to market risk, a firm should retain appropriate prudential records of:

1. (1)

   off and on market trades in financial instruments;

2. (2)

   the nature and amounts of off and on balance sheet exposures, including aggregations of exposures;

3. (3)

   trades in financial instruments and other assets and liabilities; and

4. (4)

   methods and assumptions used in stress testing and scenario analysis and in VaR models.

A firm should keep a data history to enable it to perform back testing of methods and assumptions used for stress testing and scenario analysis and for VaR models.

The scope of application of PRU 4.2 is not restricted to firms that are subject to the relevant EC directives. It applies, for example, to pure reinsurers (with the exception of PRU 4.2.53 R).

This section sets out rules and guidance relating to market risk. Under PRU 7.2.20 R, a firm is required to hold admissible assets of a value sufficient to cover technical provisions. In addition, PRU 7.2.34 R sets the requirement that a firm must hold assets of appropriate amount, currency, term, safety and yield, to ensure that the cash inflows from those assets will be sufficient to meet expected cash outflows from its insurance liabilities as they are due.

Market risk is the risk that as a result of market movements a firm may be exposed to fluctuations in the value of its assets, the amount of its liabilities, or the income from its assets. Sources of general market risk include movements in interest rates, equities, exchange rates and real estate prices. It is important to note that none of these sources of risk is independent of the others. For example, fluctuations in interest rates often have an impact upon equity and currency values and vice versa. Giving due consideration to these correlations is an important aspect of the prudent management of market risk.

A firm may also be exposed to specific market risk, which is the risk that the market value of a specific asset, or income from that asset, may fluctuate for reasons that are not dependent on general market movements. The limits in PRU 3.2.22 R cover market risk as well as counterparty risk.

PRU 4.2 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 must 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 PRU 4.2.9 G to PRU 4.2.26 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'smathematical reserve requirements. PRU 7.3 contains rules and guidance as to the methods and assumptions to be used in calculating these 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. PRU 4.2.28 R to PRU 4.2.48 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. PRU 4.2.49 G to PRU 4.2.56 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 PRU 4.2.27 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. PRU 4.2.57 R and PRU 4.2.58 R set out these cover requirements.

The resilience capital requirement forms part of the calculation of the capital resources requirement for all firms carrying on long-term insurance business. PRU 2.1.15 R to PRU 2.1.20 R set out the different elements of this calculation. These include the Minimum Capital Requirement and the Enhanced Capital Requirement. The resilience capital requirement forms part of both of these requirements (see PRU 2.1.22 R (2)and PRU 2.1.34 R (2)).

The purpose of the resilience capital requirement is to cover adverse deviation from:

1. (1)

   the value of long-term insurance liabilities;

2. (2)

   the value of assets held to cover long-term insurance liabilities; and

3. (3)

   the value of assets held to cover the resilience capital requirement;

arising from the effects of market risk for equities, real estate and fixed interest securities. Other risks are not explicitly addressed by the resilience capital requirement.

The amount of the resilience capital requirement calculated by the firm will depend on the firm's choice of assets held to cover the resilience capital requirement. The resilience capital requirement is held to cover not only the shortfall between the change in the value of long-term insurance liabilities and the change in the value of the assets identified to cover those liabilities, but also the change in the value of the assets identified to cover the resilience capital requirement itself.

As part of the assessment of the financial resources a firm needs to hold to comply with PRU 1.2.22 R, PRU 1.2.35 R requires a firm to carry out stress tests and scenario analyses appropriate to the major sources of risk to its ability to meet its liabilities as they fall due identified in accordance with PRU 1.2.31 R. In considering the stress tests and scenario analyses relevant to the major sources of risk in the category of market risk, a firm should consider the extent to which the market risk scenarios set out in PRU 4.2.16 R to PRU 4.2.26 R are appropriate to the nature of its asset portfolio. A firm may judge that given the nature of its portfolio, a more severe stress should be adopted. The firm may also wish to bring in other asset classes, such as index-linked bonds, which should be stressed on appropriate bases, and to consider the impact of currency mismatching and any derivative positions held.

The resilience capital requirement requires firms to assume different adverse market risk scenarios for equities, real estate and fixed interest securities (see PRU 4.2.16 R and PRU 4.2.23 R) to those required by PRU 7.4.68 R (UK and certain other assets) and PRU 7.4.73 R (non-UK assets) in relation to the calculation of the risk capital margin for a with-profits fund by a realistic basis life firm calculating its with-profits insurance capital component.

Where the resilience capital requirement is affected by the presence of derivative or quasi-derivative instruments, the firm will need to consider whether the protection afforded is of suitable length or security. The firm should include the exposure to counterparties in the credit considerations of PRU 4.2.41 R both before and after calculating the resilience capital requirement.If the derivative protection is very short term the firm should consider whether issues arise under PRU 7.3.26 R (Avoidance of future valuation strain); when a derivative expires the financial position of the firm may deteriorate as a result of, for example, falls in asset values. Unless the firm holds a further reserve, the firm is likely to need to have either undertaken a fresh protection strategy or carried through the alternative to the derivative protection (such as selling equities in place of a put option) if the existing protection expires before the financial year end. If the existing derivative protection continues beyond the time of financial year end the firm must have sufficient confidence that it can renew its derivative protection or an alternative to achieve the same effect.

An example of PRU 4.2.16 R (3) is that, where the long-term gilt yield is currently 6%, a firm would assume an increase of 20% in that yield, that is, a change of 1.2 percentage points. For the purpose of the scenario in PRU 4.2.16 R (3)(a), the firm would assume a fall or rise of 1.2 percentage points in yields on all fixed interest securities.

For the purpose of calculating the real estate market adjustment ratio in PRU 4.2.21 R, a firm should select an appropriate index of real estate values such that:

1. (1)

   the constituents of the index are reasonably representative of the nature and territory of the real estate included in the range of assets identified in accordance with PRU 4.2.10 R; and

2. (2)

   the frequency of, and historical data relating to, published values of the index are sufficient to enable an average value(s) of the index to be calculated over the three preceding financial years.

For the purpose of PRU 4.2.24 R (1), an appropriate equity market index for a territory is such that:

1. (1)

   the constituents of the index are reasonably representative of the nature of the equities held in that territory which are included in the range of assets identified in accordance with PRU 4.2.10 R; and

2. (2)

   the frequency of, and historical data relating to, published values of the index are sufficient to enable an average value(s) and historical volatility of the index to be calculated over at least the three preceding financial years.

The rates of interest to be used for the calculation of the present values of general insurance liabilities are specified in the insurance accounts rules. These state that the rate of interest to be used must not exceed the lowest of:

1. (1)

   a rate prudently estimated by the firm to be earned by assets of the firm that are appropriate in magnitude and nature to cover the provisions for claims being discounted, during the period necessary for the payment of such claims;

2. (2)

   a rate justified by the performance of such assets over the preceding five years; and

3. (3)

   a rate justified by the performance of such assets during the year preceding the balance sheet date.

Examples of calculating a combined yield for the purposes of PRU 4.2.30 R (1):

1. (1)

   1000 £1 shares (fully paid) of ABC plc covered by a sold future on the shares. Calculating the combined yield effectively results in a position that behaves like cash (with dividend income but no capital gain or loss on the value of the assets); and

2. (2)

   where a covering derivative contains an option exercisable by the firm (e.g. a bought put option or receiver swaption), the calculation of the risk adjusted yield should take into account the fact that on the valuation assumptions any time value will reduce over time (known as the 'wasting' nature of the time value of the option), for example, an at-the money option will expire worthless and hence the covering derivative will effectively be a negative yielding asset. There are various ways of allowing for this, for example a firm could treat the covering derivative and the asset as a single asset and calculate an internal rate of return on this combined asset. Alternatively, an explicit reserve could be set up equal and opposite to the time value of the covering derivative which would be written off in the same way as the time value on the covering derivative.

The requirements in relation to offsetting transactions are set out in PRU 4.3. The options and other rights referred to in PRU 4.2.30 R (4) include those exercisable by the firm as well as those exercisable by other parties.

The risk adjusted yield for a collective investment scheme may be determined as the weighted average of the yields on each of the investments held by the collective investment scheme.

An allowance for credit risk should be made for all securities except risk-free securities.

Provision for credit risk for credit-rated securities may be made by reference to historic default rates of securities with a similar credit rating. However, allowance should be made both for any recent or expected changes in market conditions that may invalidate historic default rates and for the likelihood that the credit ratings on securities may deteriorate or (following such deterioration) that the issuer may default.

The purpose of PRU 4.2.45 R to PRU 4.2.47 R is to help protect against 'reinvestment risk'. Reinvestment risk is the risk that, when the sums are actually received, interest rates (and so yields available on assets) might have fallen below current expectations.

Fluctuations in foreign exchange rates may impact adversely upon a firm, including where it holds an open position in a foreign currency. This is where future cash outflows (that is liabilities) in one currency are matched by future cash inflows (that is assets) in a different currency. The circumstances in which this could arise include where the firm:

1. (1)

   has entered into contracts for the purchase or sale of foreign currency; or

2. (2)

   has entered into contracts of insurance under which claims are payable in, or determined by reference to a value or price expressed in, a foreign currency; or

3. (3)

   holds assets denominated in a foreign currency.

The requirements in relation to cover and offsetting transactions are set out in PRU 4.3.

PRU 7.2.34 R requires a firm to cover its liabilities with assets that enable it to match, in timing, amount and currency, the cash inflows and outflows from those assets and liabilities. This permits some currency mismatching of assets and liabilities, but only if sufficient excess assets are held to cover the exposure arising from such mismatching. The level of permitted currency mismatching is also limited by PRU 4.2.53 R.

The reasonable grounds in PRU 4.2.55 R (2) include if, from the time the contract is entered into, it appears likely that a claim will be paid in the currency of the premium and not in the currency of the country in which the risk is situated.

For the purposes of PRU 4.2.57 R and PRU 4.2.58 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) and Earnings Index), 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 a 5% fixed interest bond or a RPI bond.

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 PRU 3.2.

The scope of application of PRU 4.3 is not restricted to firms that are subject to the relevant EC directives. It applies, for example, to pure reinsurers.

PRU 2.2.12 R requires a firm to calculate its capital resources for the purpose of PRU in accordance with Table PRU 2.2.14 R, subject to the limits in PRU 2.2.16 R to PRU 2.2.26 R. Table PRU 2.2.14 R and PRU 2.2.86 R require a firm to deduct from total capital resources the value of any asset included in an insurance fund which is not an admissible asset as listed in PRU 2 Annex 1R.PRU 2 Annex 1R provides that a derivative, quasi-derivative or stock lending transaction will only be an admissible asset if it is approved. This section sets out the criteria for determining when a derivative, quasi-derivative or stock lending transaction is approved for this purpose. PRU 4.3.5 R to PRU 4.3.35 R set out the criteria for derivatives and quasi-derivatives. PRU 4.3.36 R to PRU 4.3.41 R set out the criteria for stock lending transactions.

PRU 4.3.8 R does not require that a derivative or quasi-derivative has no possible adverse consequences. Often a derivative or quasi-derivative is effected to protect against a severe adverse consequence that only arises in one circumstance. In all other circumstances it may itself lead to adverse consequences, even if only because it expires worthless resulting in the loss of the purchase price. Conversely a derivative or quasi-derivative may reduce risk in a wide range of circumstances but lead to adverse consequences when a particular circumstance arises, e.g. the default of the counterparty. Only rarely does a derivative or quasi-derivative give rise to no adverse consequences in any circumstances. The test is merely that the increase in risk should not be significant, that is it should be both small and reasonable, or the risk should be remote.

Firms are reminded that PRU 3.2 (Credit risk in insurance) sets out the different types of loss mitigation techniques.

In assessing whether investment risk is reduced, the impact of a transaction on both the assets and liabilities should be considered. In particular, where the amount of liabilities depends upon the fluctuations in an index or other factor, investment risk is reduced where assets whose value fluctuates in the same way match those liabilities. In appropriate circumstances this may include:

1. (1)

   a derivative or quasi-derivative that is linked to the same index as the liabilities from the index-linked contracts; and

2. (2)

   a derivative or quasi-derivative whose value depends upon the factors which give rise to general insurance claims, e.g. a weather quasi-derivative.

Where a firm partially covers a derivative (or other contract falling within PRU 4.3.14 R (1) and PRU 4.3.14R (2)), the firm may split the derivative into a covered portion and an uncovered portion. The portion of the derivative that is covered (after taking into account the requirement to cover reasonably foreseeable adverse variations in PRU 4.3.17 R (1)) is an approved derivative, provided it also meets the requirements in PRU 4.3.5 R (1) and PRU 4.3.5 R (3); the uncovered portion is not an approved derivative.

Exposure to a transaction includes exposure that arises from a right at the firm's (or its subsidiary undertaking's) option to dispose of assets.

Cover serves three purposes. First, it protects against exposure to loss from the transaction which is being covered. The value of the cover increases (or if the cover is a liability the amount of that liability decreases) to match any increase in obligations under the transaction.

The second purpose of cover is that it prevents excessive gearing in the investment portfolio by the use of options and their equivalent. A firm is required to cover all obligations under an admissible transaction including obligations that would arise only at the option of the firm, e.g. the liability to pay the exercise price under a bought option.

The third purpose of cover is that it protects against the risk that the firm may not be able to deliver assets (including money in any currency) of the right type when the obligation falls due under the transaction. An obligation to deliver assets is covered only if the firm holds those assets or has entered into an offsetting transaction that would deliver those assets when needed. An obligation to pay money is offset only if the firm holds cash in the right currency, its equivalent or assets that could reliably be converted into cash in the right currency.

PRU 4.3.30 R in effect allows borrowings to be used to bridge the gap between an obligation under a transaction that might fall due at one date and cash or its equivalent that would only become due at a later date. Borrowings may not be used to gear the investment portfolio.

Examples of cover by assets for the purposes of PRU 4.3.16 R:

1. (1)

   a bought put option (or a sold call option) on 1000 £1 shares (fully paid) of ABC plc is covered by an existing holding in the fund of 1000 £1 shares (fully paid) of ABC plc;

2. (2)

   a bought call option (or sold put option) on 1000 ordinary £1 shares (fully paid) of ABC plc is covered by cash (or its equivalent) which is sufficient in amount to meet the purchase price of the shares on exercise of the option;

3. (3)

   a bought or sold contract for differences on short-dated sterling is covered by cash (or its equivalent), the value of which together at least match the notional principal of the contract. For example, a LIFFE short sterling contract, or a successive series of such contracts, is covered by £500,000; and

4. (4)

   a sold future on the FT-SE 100 index is covered by holdings of equities, which satisfy the reasonable approximation test for cover in PRU 4.3.16 R (2) in relation to that future, and the values of which together at least match the current mark to market valuation of the future. For example, if the multiplier per full point is £10, and if the eventual obligation under the future is currently 2800, the valuation of the futures position is 2800 x £10 = £28,000.

Examples of cover by offsetting transactions for the purpose of PRU 4.3.25 R would include a bought future which is guaranteed to deliver to the firm at the relevant time sufficient assets to cover liabilities under a sold call option.

PRU 4.3.36 R refers only to stock lending transactions where the firm is the lender. There are no special rules for a transaction under which the firm borrows securities.

For the purposes of assessing adequate quality in PRU 4.3.38 R (3), reference should be made to the criteria for credit risk loss mitigation set out in PRU 3.2.16 R. The valuation rules in PRU 1.3 apply for the purpose of determining the value of both collateral received and the securities transferred. In addition, collateral that is not an admissible asset does not have a value (see PRU 2 Ann 1).