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# PRU 7.3 Mathematical reserves

## Application

PRU 7.3.1R

PRU 7.3 applies to a long-term insurer unless it is:

1. (1)
2. (2)

an incoming EEA firm; or

3. (3)

## Purpose

PRU 7.3.2G

This section follows on from the overall requirement on firms to establish adequate technical provisions (see PRU 7.2.16 R). The mathematical reserves form the main component of technical provisions for long-term insurance business. PRU 7.3 sets out rules and guidance as to the methods and assumptions to be used in calculating the mathematical reserves. The rules and guidance set out the minimum basis for mathematical reserves. Methods and assumptions that produce reserves that are demonstrably equal to or greater than the minimum basis may also be used, though they must meet the basic requirements for methods and assumptions set out in PRU 7.3.7 R to PRU 7.3.27 G.

PRU 7.3.3G

This section applies to all firms carrying on long-term insurance business and implements some of the requirements contained in article 20 of the Consolidated Life Directive. The implementation is designed to ensure that a firm's mathematical reserves in respect of long-term insurance contracts meet the minimum requirements set by the Consolidated Life Directive. A firm may use a prospective or a retrospective method to value its mathematical reserves(see PRU 7.3.7 R).

PRU 7.3.4G

The required procedures are summarised in the flowchart inPRU 7 Annex 1G.

PRU 7.3.5G

Firms to which PRU 2.1.15R applies are required to calculate a with-profits insurance capital component (see PRU 2.1.34 R). In order to calculate its with-profits insurance capital component, such a firm is required to carry out additional calculations of its liabilities on a realistic basis (see PRU 7.4), which it is required to report to the FSA (see Forms 18,19). A firm that reports its liabilities on a realistic basis is referred to in PRU as a realistic basis life firm. Such firms are subject to different rules relating to the calculation of mathematical reserves (see PRU 7.3.46 R and PRU 7.3.76 R) compared with those that apply to firms that report on a regulatory basis only (regulatory basis only life firms).

PRU 7.3.6G

A number of the rules in this section require a firm to take into account its regulatory duty to treat customers fairly. In this section, references to such a duty are to a firm's duty to pay due regard to the interests of its customers and to treat them fairly (see Principle 6 in PRIN). This duty is owed to both policyholders and potential policyholders.

## Basic valuation method

PRU 7.3.7R

1. (1)

Subject to (2), a firm must establish its mathematical reserves using a prospective actuarial valuation on prudent assumptions of all future cash flows expected to arise under, or in respect of, each of its long-term insurance contracts.

2. (2)

But a firm may use a retrospective actuarial valuation where:

1. (a)

a prospective method cannot be applied to a particular type of contract; or

2. (b)

the firm can demonstrate that the resulting amount of the mathematical reserves would be no lower than would be required by a prudent prospective actuarial valuation.

PRU 7.3.8G

A prospective valuation sets the mathematical reserves at the present value of future net cash flows. A retrospective method typically sets the mathematical reserves at the level of premiums received (and accumulated with investment return), less claims and expenses paid. A prospective valuation is preferred because it takes account of circumstances that might have arisen since the premium rate was set and of changes in the perception of future experience. Circumstances in which a retrospective valuation might be appropriate include:

1. (1)

where the assumptions initially made in determining the premium rate were sufficiently prudent at inception and have not been overtaken by subsequent events; and

2. (2)

where the liability depends on the emerging experience.

PRU 7.3.9R

Except in PRU 7.3.71 R (1), PRU 7.3 does not apply to final bonuses. In addition, for realistic basis life firms only, PRU 7.3 does not apply to future annual bonuses.

## Methods and assumptions

PRU 7.3.10R

In the actuarial valuation under PRU 7.3.7 R, a firm must use methods and prudent assumptions which:

1. (1)

are appropriate to the business of the firm;

2. (2)

are consistent from year to year without arbitrary changes (see PRU 7.3.11 G);

3. (3)

are consistent with the method of valuing assets (see PRU 1.3);

4. (4)

include appropriate margins for adverse deviation of relevant factors (see PRU 7.3.12 G);

5. (5)

recognise the distribution of profits (that is, emerging surplus) in an appropriate way over the duration of each contract of insurance;

6. (6)

take into account its regulatory duty to treat its customers fairly (see Principle 6); and

7. (7)

are in accordance with generally accepted actuarial practice.

PRU 7.3.11G

PRU 7.3.10 R (2) prohibits only arbitrary changes in methods and assumptions, that is, changes made without adequate reasons. Any such changes would hinder comparisons over time as to the amount of the mathematical reserves and so obscure trends in solvency and the emergence of surplus.

PRU 7.3.12G

The relevant factors referred to in PRU 7.3.10 R (4) may include, but are not limited to, factors such as future investment returns, expenses, mortality, morbidity, options, persistency and reinsurance (see also PRU 7.3.13 R to PRU 7.3.19 G).

## Margins for adverse deviation

PRU 7.3.13R

The appropriate margins for adverse deviation required by PRU 7.3.10 R (4) must be sufficiently prudent to ensure that there is no significant foreseeable risk that liabilities to policyholders in respect of long-term insurance contracts will not be met as they fall due.

PRU 7.3.14G

The margins for adverse deviation are a prudential margin in respect of the risks that arise under a long-term insurance contract.

PRU 7.3.15G

PRU 7.3.13 R sets the normal standard of prudence required for margins. PRU 7.3.16 G suggests benchmarks against which a firm should compare the margins it has set in accordance with PRU 7.3.10 R (4) and PRU 7.3.13 R. PRU 7.3.17 G gives guidance where a market risk premium is not readily obtainable.

PRU 7.3.16G

When setting the margins for adverse deviation required by PRU 7.3.10 R (4) in relation to a particular contract, a firm should consider, where appropriate:

1. (1)

the margin for adverse deviation included in the premium for similar long-term insurance contracts, if any, newly issued by the firm; and

2. (2)

where a sufficiently developed and diversified market for transferring a risk exists, the risk premium that would be required by an unconnected party to assume the risk in respect of the contract.

The margin for adverse deviation of a risk should generally be greater than or equal to the relevant market price for that risk.

PRU 7.3.17G

Where a risk premium is not readily available, or cannot be determined, an external proxy for the risk should be used, such as adjusted industry mortality tables. Where there is a considerable range of possible outcomes, the FSA expects firms to use stochastic techniques to evaluate these risks. In time, for example, longevity risk, where this constitutes a significant risk for the firm, may fall into this category.

PRU 7.3.18G

The margins for adverse deviation should be recognised as profit only as the firm itself is released from risk over the duration of the contract.

PRU 7.3.19G

Further detailed rules and guidance on margins for adverse deviation are included in PRU 7.3.32 G to PRU 7.3.91 G. In particular, the cross-references for the different assumptions used in calculating the mathematical reserves are as follows:

1. (1)

expenses (PRU 7.3.50 R to PRU 7.3.58 G);

2. (2)

mortality and morbidity (PRU 7.3.59 R to PRU 7.3.61 G);

3. (3)

options (PRU 7.3.62 R to PRU 7.3.72 G);

4. (4)

persistency (PRU 7.3.73 G to PRU 7.3.77 G); and

5. (5)

The rules and guidance on margins for adverse deviation in respect of future investment returns, which are also required in the calculation of mathematical reserves, are set out in PRU 4.2.28 R to PRU 4.2.48 G.

## Record keeping

PRU 7.3.20R

A firm must make, and retain for an appropriate period, a record of:

1. (1)

the methods and assumptions used in establishing its mathematical reserves, including the margins for adverse deviation, and the reasons for their use; and

2. (2)

the nature of, reasons for, and effect of, any change in approach, including the amount by which the change in approach increases or decreases its mathematical reserves.

PRU 7.3.21G

PRU 1.4.53 R requires firms to maintain accounting and other records for a minimum of three years, or longer as appropriate. For the purposes of PRU 7.3.20 R, a period of longer than three years will be appropriate for a firm's long-term insurance business. In determining an appropriate period, a firm should have regard to:

1. (1)

the detailed rules and guidance on record keeping in PRU 1.4.51 G - PRU 1.4.64 G;

2. (2)

the nature and term of the firm's long-term insurance business; and

3. (3)

any additional provisions or statutory requirements applicable to the firm or its records.

## Valuation of individual contracts

PRU 7.3.22R

1. (1)

Subject to (2) and (3), a firm must determine the amount of the mathematical reserves separately for each long-term insurance contract.

2. (2)

Approximations or generalisations may be made where they are likely to provide the same, or a higher, result.

3. (3)

A firm must set up additional mathematical reserves on an aggregated basis for general risks that are not specific to individual contracts.

PRU 7.3.23G

PRU 7.3.22 R to PRU 7.3.91 G set out rules and guidance for the separate prospective valuation of each contract. These may be applied instead to groups of contracts where the conditions set out in PRU 7.3.22 R (2) are satisfied.

## Contracts not to be treated as assets

PRU 7.3.24R

A firm must not treat a long-term insurance contract as an asset.

PRU 7.3.25G

A separate prospective valuation for each contract may identify contracts for which the value of future cash inflows exceeds that of outflows, that is, the contracts have an asset value, rather than liability value. However, the surrender value of a contract is always greater than or equal to zero and the Consolidated Life Directive requires that no contract should be valued at less than its guaranteed surrender value. As a result, no contract should be treated as an asset.

## Avoidance of future valuation strain

PRU 7.3.26R

1. (1)

A firm must establish mathematical reserves for a contract of insurance which are sufficient to ensure that, at any subsequent date, the mathematical reserves then required are covered solely by:

1. (a)

the assets covering the current mathematical reserves; and

2. (b)

the resources arising from those assets and from the contract itself.

2. (2)

For the purposes of (1), the firm must assume that:

1. (a)

the assumptions adopted for the current valuation of liabilities remain unaltered and are met; and

2. (b)

discretionary benefits and charges will be set so as to fulfil its regulatory duty to treat its customers fairly.

3. (3)

(1) may be applied to a group of similar contracts instead of to the individual contracts within that group.

PRU 7.3.27G

The valuation of each contract, or group of similar contracts, should allow for the possibility, where it exists, that contracts may be surrendered (wholly or in part), lapsed or made paid-up at any time. The valuation assumptions include margins for adverse deviation (see PRU 7.3.13 R). PRU 7.3.26 R requires mathematical reserves to be established such that, if future experience is in line with the valuation assumptions, there would be no future valuation strain.

## Cash flows to be valued

PRU 7.3.28R

In a prospective valuation, a firm must include the following in the cash flows to be valued:

1. (1)

future premiums (see PRU 7.3.35 G to PRU 7.3.47 G);

2. (2)

expenses, including commissions (see PRU 7.3.50 R to PRU 7.3.58 G);

3. (3)

benefits payable (see PRU 7.3.29 R); and

4. (4)

amounts to be received or paid in respect of the long-term insurance contracts under contracts of reinsurance or analogous non-reinsurance financing agreements (PRU 7.3.78 G to PRU 7.3.91 G).

PRU 7.3.29R

For the purpose of PRU 7.3.28 R (3), benefits payable include:

1. (1)

all guaranteed benefits including guaranteed surrender values and paid-up values;

2. (2)

vested, declared and allotted bonuses to which the policyholder is entitled;

3. (3)

all options available to the policyholder under the terms of the contract; and

4. (4)

discretionary benefits payable in accordance with the firm's regulatory duty to treat its customers fairly.

PRU 7.3.30G

All cash flows are to be valued using prudent assumptions in accordance with generally accepted actuarial practice. Cash flows may be omitted from the valuation calculations provided the reserves obtained as a result of leaving those cash flows out of the calculation are not less than would have resulted had all cash flows been included (see PRU 7.3.22 R (2)). Provision for future expenses in respect of with-profits insurance contracts (excluding accumulating with-profits policies) may be made implicitly, using the net premium method of valuation (see PRU 7.3.43 R below). For the purposes of PRU 7.3.28 R (2), any charges included in expenses should be determined in accordance with the firm's regulatory duty to treat its customers fairly.

PRU 7.3.31G

PRU 7.3.29 R (4) requires regulatory basis only life firms to make allowance for any future annual bonus that a firm would expect to grant, assuming future experience is in line with the assumptions used in the calculation of the mathematical reserves. Final bonuses do not have to be taken into consideration in these calculations (see PRU 7.3.9 R). For realistic basis life firms, except for accumulating with-profits policies, the mathematical reserves may be calculated as the amount required to cover guaranteed benefits as for such firms full allowance for discretionary benefits is made in the calculation of the realistic value of liabilities (see PRU 7.4.105 R (5)). The calculations required for accumulating with-profits policies are set out in PRU 7.3.71 R (1).

## Valuation assumptions: detailed rules and guidance

PRU 7.3.32G

More detailed rules and guidance about the valuation of cash flows are set out in PRU 7.3.33 R to PRU 7.3.91 G.

## Valuation rates of interest

PRU 7.3.33R

In calculating the present value of future net cash flows, a firm must determine the rates of interest to be used in accordance with PRU 4.2.28 R to PRU 4.2.47 R.

PRU 7.3.34G

The rules in PRU 4.2.28 R to PRU 4.2.47 R set out the approach firms must take in setting margins for adverse deviation in the interest rates assumed in calculating the mathematical reserves. This includes a margin to allow for adverse deviation in market risk and, where relevant, credit risk. The requirements set out in PRU 4.2.28 R to PRU 4.2.47 R protect against the market risk that the return actually achieved on assets may fall below the market yields on assets at the actuarial valuation date.

PRU 7.3.36G

For non-profit insurance contracts no specific method of valuation for future premiums is required by PRU. However, the method of valuation used should be sufficiently prudent taking into account, in particular, the risk of voluntary discontinuance by the policyholder.

## Future premiums: firms reporting only on a regulatory basis

PRU 7.3.37R
PRU 7.3.38R

1. (1)

This rule applies to with-profits insurance contracts except accumulating with-profits policies written on a recurring single premium basis.

2. (2)

The value attributed to a premium due in any future financial year (a future premium) must not exceed the lower of the value of:

1. (a)

the actual premium payable under the contract; and

2. (b)

3. (3)

The net premium may be increased for deferred acquisition costs in accordance with PRU 7.3.43 R.

PRU 7.3.39G

The valuation method for future premiums in PRU 7.3.38 R retains the difference, if any, between the gross premium and the net premium as an implicit margin available to finance future bonuses, expenses and other costs. It thus helps to protect against the risk that adequate resources may not be available in the future to meet those costs.

PRU 7.3.40R

Where the terms of a contract of insurance have changed since it was first entered into, a firm must apply one of the methods in PRU 7.3.41 R in determining the net premium for the purpose of PRU 7.3.38 R (2)(b).

PRU 7.3.41R

A firm must treat the change referred to in PRU 7.3.40 R as if either:

1. (1)

it had been included in the original contract but came into effect from the time the change became effective; or

2. (2)

the original contract were cancelled and replaced by a new contract (with an initial premium paid on the new contract equal to the liability under the original contract immediately prior to the change); or

3. (3)

it gave rise to two separate contracts where:

1. (a)

all premiums are payable under the first contract and that contract provides only for such benefits as those premiums could have purchased from the firm at the date the change became effective; and

2. (b)

no premiums are payable under the second contract and that contract provides for all the other benefits.

PRU 7.3.42G

PRU 7.3.41 R permits three alternative methods. However, the third method is only possible where a meaningful comparison can be made between the terms of the contract (as changed) and the terms upon which the firm was effecting its new contracts of insurance at the time the contract was changed.

## Future net premiums: adjustment for deferred acquisition costs

PRU 7.3.43R

1. (1)

The amount of any increase to the net premium for deferred acquisition costs must not exceed the equivalent of the recoverable acquisition expenses spread over the period of premium payments and calculated in accordance with the rates of interest, mortality and morbidity assumed in calculating the mathematical reserves.

2. (2)

For the purpose of (1), recoverable acquisition expenses means the amount of expenses, after allowing for the effects of taxation, which it is reasonable to expect will be recovered from future premiums payable under the contract.

3. (3)

The recoverable acquisition expenses in (1) must not exceed the lower of:

1. (a)

the value of the excess of actual premiums over net premiums; and

2. (b)

3.5% of the relevant capital sum.

4. (4)

Recoverable acquisition expenses may be calculated as the average for a group of similar contracts weighted by the relevant capital sum for each contract.

PRU 7.3.44G

PRU 7.3.43 R allows a firm to spread acquisition costs over the lifetime of a contract of insurance, but only if it is reasonable to expect those costs to be recoverable from future premium income from that contract. Further prudence is provided by the limitation of recoverable acquisition expenses to 3.5% of the relevant capital sum. This adjustment for acquisition costs is sometimes termed a Zillmer adjustment.

PRU 7.3.45G

In determining the extent, if any, to which it is reasonable to expect acquisition costs to be recoverable from future premium income, the firm should make prudent assumptions as to levels of voluntary discontinuance by policyholders.

## Future premiums: firms also reporting with-profits insurance liabilities on a realistic basis

PRU 7.3.46R

1. (1)

Subject to (2), for a realistic basis life firm, the future premiums to be valued in the calculation of the mathematical reserves for its with-profits insurance contracts must not be greater than the gross premiums payable by the policyholder.

2. (2)

This rule does not apply to accumulating with-profits policies written on a recurring single premium basis (see PRU 7.3.48 R).

PRU 7.3.47G

The gross premium is the full amount of premium payable by the policyholder to the firm. The gross premium method contrasts with the net premium method which is required from regulatory basis only life firms (see PRU 7.3.37 R to PRU 7.3.45 G).

## Future premiums: accumulating with-profits policies

PRU 7.3.48R

1. (1)

This rule applies to accumulating with-profits policies written on a recurring single premium basis.

2. (2)

A firm must not attribute any value to a future premium under the contract.

3. (3)

Any liability arising only upon the payment of that premium may be ignored except to the extent that the value of that liability upon payment would exceed the amount of that premium.

PRU 7.3.49G

PRU 7.3.48 R prohibits a firm from taking credit for recurring single premiums under accumulating with-profits policies. As there is no contractual commitment to pay any future premiums the amount and timing of which are uncertain, the recognition of any potential margins would not be prudent. Where the payment of a future premium would give rise to a liability in excess of the premium a provision should be established.

## Expenses

PRU 7.3.50R

1. (1)

A firm must make provision for expenses, either implicitly or explicitly, in its mathematical reserves of an amount which is not less than the amount expected, on prudent assumptions, to be incurred in fulfilling its long-term insurance contracts.

2. (2)

For the purpose of (1), expenses must be valued:

1. (a)

after taking account of the effect of taxation;

2. (b)

having regard to the firm's actual expenses in the last 12 months before the actuarial valuation date and any increases in expenses expected to occur in the future;

3. (c)

after making prudent assumptions as to the effects of inflation on future increases in prices and earnings; and

4. (d)

at no less than the level that would be incurred if the firm were to cease to transact new business 12 months after the actuarial valuation date.

3. (3)

A firm must not rely upon an implicit provision arising from the method of valuing future premiums except to the extent that:

1. (a)

it is reasonable to assume that expenses will be recoverable from future premiums; and

2. (b)

the expenses would only arise if the future premiums were received.

PRU 7.3.51G

For with-profits insurance contracts where the net premium valuation method applies, an implicit provision arises because the future premiums valued are limited to the net premium adjusted as permitted by PRU 7.3.43 R. This excludes the allowance within the gross premium for expenses (other than recoverable acquisition expenses). It also excludes other margins within the actual premium that are a prudential margin in respect of the risks that arise under the contract or that are needed to provide for future discretionary benefits. To the extent that these other margins are not needed for the purpose for which they were originally established, they may also constitute an implicit provision for expenses.

PRU 7.3.52G

An implicit provision may also arise for other types of long-term insurance contract where, for example, no value is attributed to future premiums, but the firm is entitled to make deductions from future regular premiums before allocating them to secure policyholder benefits.

PRU 7.3.53G

A firm should only reduce the provision for future expenses to take account of expected taxation recoveries related to those expenses where recovery is reasonably certain, and after taking into account the assumption that the firm ceases to transact new business 12 months after the actuarial valuation date. An appropriate adjustment for discounting should be made where receipt of the taxation recoveries is not expected until significantly after the expenses are incurred.

PRU 7.3.54G

The firm's actual expenses in the 12 months prior to the actuarial valuation date may serve as a guide to the assumptions for future expenses, taking into consideration the mix of acquisition and renewal expenses. The expense assumptions should not be reduced to account for expected future improvements in efficiency until such efficiency improvements result in a reduced level of actual expenditure. However, the assumptions should take account of all factors which might increase costs including earnings and price inflation.

PRU 7.3.55R

The provisions for expenses (whether implicit or explicit) required by PRU 7.3.50 R must be sufficient to cover all the expenses of running off the firm's existing long-term insurance business including:

1. (1)

all discontinuance costs (for example, redundancy costs and closure costs) that would arise if the firm were to cease transacting new business 12 months after the actuarial valuation date in circumstances where (and to the extent that) the discontinuance costs exceed the projected surplus available to meet such costs;

2. (2)

all costs of continuing to service the existing business taking into account the loss of economies of scale from, and any other likely consequences of, ceasing to transact new business at that time; and

3. (3)

the lower of:

1. (a)

any projected valuation strain from writing new business for the 12 months following the actuarial valuation date to the extent the actual amount of that strain exceeds the projected surplus on prudent assumptions from existing business in the 12 months following the actuarial valuation date; and

2. (b)

any projected new business expense overrun from writing new business for the 12 months following the actuarial valuation date to the extent the projected expenses exceed the expenses that the new business can support on a prudent basis.

PRU 7.3.56G

The provision for future expenses, whether implicit or explicit, should include a prudent margin for adverse deviation in the level and timing of expenses (see PRU 7.3.13 R to PRU 7.3.19 G). The margin should cover the risk of underestimating expenses whether due to, for example, initial under-calculation or subsequent increases in the amount of expenses. In setting the amount of the margin, the firm should take into account the extent to which:

1. (1)

an appropriately validated method based on reliable data is used to allocate expenses by product type, by distribution channel and as between acquisition and non-acquisition expenses;

2. (2)

the volume of existing and new business and its distribution by product type or distribution channel is stable or predictable;

3. (3)

costs vary in the short, medium or long term dependent upon the volume of existing or new business and its distribution by product type or distribution channel; and

4. (4)

cost control is well-managed.

PRU 7.3.57G

In setting the margin, the firm should also take into account:

1. (1)

the length of the period over which it is necessary to project costs;

2. (2)

the extent to which it is reasonable to expect inflation to be stable or predictable over that period; and

3. (3)

whether, if inflation is higher than expected, it is reasonable to expect that the excess would be offset by increases in investment returns.

PRU 7.3.58G

Where a firm has entered into an agreement with any other person for the sharing or reimbursement of costs, in setting the margin it should take into account the potential impact of that agreement and of its discontinuance.

## Mortality and Morbidity

PRU 7.3.59R

A firm must set the assumptions for mortality and morbidity using prudent rates of mortality and morbidity that are appropriate to the country or territory of residence of the person whose life or health is insured.

PRU 7.3.60G

The rates of mortality or morbidity should contain prudent margins for adverse deviation (see PRU 7.3.13 R to PRU 7.3.19 G). In setting those rates, a firm should take account of:

1. (1)

the systems and controls applied in underwriting long-term insurance contracts and whether they provide adequate protection against anti-selection (that is, selection against the firm) including:

1. (a)

adequately defining and identifying non-standard risks; and

2. (b)

where such risks are underwritten, allocating to them an appropriate weighting;

2. (2)

the nature of the contractual exposure to mortality or morbidity risk including:

1. (a)

whether lower mortality increases or decreases the firm's liability;

2. (b)

the period of cover and whether risk charges can be varied during that period and, if so, how quickly; and

3. (c)

whether the options in the contract give rise to a significant risk of anti-selection (for example, opportunities for voluntary discontinuance, guaranteed renewal at the option of the policyholder and rights for conversion of benefits);

3. (3)

the credibility of the firm's actual experience as a basis for projecting future experience including:

1. (a)

whether there is sufficient data (especially for medical or financial risks and for new types of benefit or new methods of distribution); and

2. (b)

whether the data is reliable and has been appropriately validated;

4. (4)

the availability and reliability of:

1. (a)

any published tables of mortality or morbidity for the country or territory of residence of the person whose life or health is insured; and

2. (b)

any other information as to the industry-wide insurance experience for that country or territory;

5. (5)

anticipated or possible future trends in experience including, but only where they increase the liability:

1. (a)

anticipated improvements in mortality;

2. (b)

changes arising from improved detection of morbidity (including critical illnesses);

3. (c)

diseases the impact of which may not yet be reflected fully in current experience; and

4. (d)

changes in market segmentation (such as impaired life annuities) which, in the light of developing experience, may require different assumptions for different parts of the policy class.

PRU 7.3.61G

An additional provision for diseases covered by PRU 7.3.60 G (5)(c) may be needed, in particular for unit-linked policies. In determining whether such a provision is needed a firm may take into consideration any ability to increase product charges commensurately (provided that such increase does not infringe on its regulatory duty to treat its customers fairly), but a provision would still be required for the period until such an increase could be brought into effect.

## Options

PRU 7.3.62R

When a firm establishes its mathematical reserves in respect of a long-term insurance contract, the firm must include an amount to cover any increase in liabilities which might be the direct result of its policyholder exercising an option under, or by virtue of, that contract of insurance. Where the surrender value of a contract is guaranteed, the amount of the mathematical reserves for that contract at any time must be at least as great as the value guaranteed at that time.

PRU 7.3.63G

An option exists where a policyholder is given a choice between alternative forms of benefit, for example, a choice between receiving a cash benefit upon maturity or an annuity at a guaranteed rate. In some cases, the contract may designate one or other of these alternatives as the principal benefit and any other as an option. This designation, in itself, is not one of substance in the context of reserving since it does not affect the policyholder's choices. Other forms of option include:

1. (1)

the right to convert to a different contract on guaranteed terms;

2. (2)

the right to increase cover on guaranteed terms;

3. (3)

the right to a specified amount on surrender; and

4. (4)

the right to a paid up value.

PRU 7.3.64G

The firm should provide for the benefit which the firm anticipates the policyholder is most likely to choose. Except for the "option" of voluntary discontinuance in the case of regulatory basis only life firms (see PRU 7.3.74 R), past experience may be used as a guide, but only if this is likely to give a reasonable estimate of future experience. For example, past experience of the take-up of a cash payment option instead of an annuity would not be a reliable guide, if, in the past, market rates exceeded those guaranteed in the annuity but no longer do so. Similarly, past experience on the take-up of options may not be relevant in the light of the assumptions made in respect of future interest rates and mortality rates in the valuation of the benefits.

PRU 7.3.65G

Many options are long-term and need careful consideration. Improving longevity, for example, can increase the value of guaranteed annuity options vesting further in the future. Firms also need to have regard to the fact that policyholder behaviour can change in the future as policyholders become more aware of the value of their options. The impact on policyholder behaviour of possible changes in taxation should also be considered.

PRU 7.3.66G

In accordance with PRU 7.3.7 R and PRU 7.3.13 R, take-up rates for guaranteed annuity options should be assessed on a prudent basis with assumptions that include margins for adverse deviation (see PRU 7.3.13 R to PRU 7.3.19 G) that take account of current experience and the potential for future change. The firm should reserve for option take-up at least at a prudent margin over current experience for options shortly to vest. For longer term options where the option becomes increasingly valuable in the future due to projected mortality improvements, increased take-up rates should be assumed. In view of the growing uncertainty over take-up rates for projections further in the future, for guaranteed annuity option dates 20 years or more ahead at least a 95% take-up rate assumption should be made.

PRU 7.3.67G

Where there is considerable variation in the cost of the option depending on conditions at the time the option is exercised, and where that variation constitutes a material risk for the firm, it will generally be appropriate to use stochastic modelling. In this case prices from the asset model used in the stochastic approach should be benchmarked to relevant market asset prices before determining the value of the option. Where stochastic modelling is not undertaken, market option prices should be used to determine suitable assumptions for the valuation of the option. If no market exists for a particular option, a firm should take the value of the nearest equivalent benefit or right for which a market exists and document the way in which it has adjusted that valuation to reflect the original option.

PRU 7.3.68G

Where the option offers a choice between two non-discretionary financial benefits (such as between a guaranteed cash sum or a guaranteed annuity value, or between a unit value and a maturity guarantee) and where there is a wide range of possible outcomes, the firm should normally model such liabilities stochastically. In carrying out such modelling firms should take into account the likely choices to be made by policyholders in each scenario. Firms should make and retain a record of the development and application of the model.

PRU 7.3.69G

The value of a contract with an option is greater than the value of a similar contract without the option, that is, the option has value whether it is expected to be exercised or not. Although in theory a firm can rebalance its investments to match the expected cost of the option to the firm (including the time value of the option), this takes time to achieve and the market may move more quickly than the firm is able to respond. Also, there are likely to be transaction costs. Firms should take these aspects into consideration in setting up mathematical reserves.

PRU 7.3.70R

1. (1)

Where a policyholder may opt to be paid a cash amount, or a series of cash payments, the mathematical reserves for the contract of insurance established under PRU 7.3.7 R must be sufficient to ensure that the payment or payments could be made solely from:

1. (a)

the assets covering those mathematical reserves; and

2. (b)

the resources arising from those assets and from the contract itself.

2. (2)

In (1) references to a cash amount or a series of cash payments include the amount or amounts likely to be paid on a voluntary discontinuance.

3. (3)

For the purposes of (1), the firm must assume that:

1. (a)

the assumptions adopted for the current valuation remain unaltered and are met; and

2. (b)

discretionary benefits and charges will be set so as to fulfil the firm's regulatory duty to treat its customers fairly.

4. (4)

(1) may be applied to a group of similar contracts instead of to the individual contracts within that group.

PRU 7.3.71R

For the purposes of PRU 7.3.70 R, a firm must assume that the amount of a cash payment secured by the exercise of an option is:

1. (1)

in the case of an accumulating with-profits policy, the lower of:

1. (a)

the amount which the policyholder would reasonably expect to be paid if the option were exercised, having regard to the representations made by the firm and including any expectations of a final bonus; and

2. (b)

that amount, disregarding all discretionary adjustments;

2. (2)

in the case of any other policy, the amount which the policyholder would reasonably expect to be paid if the option were exercised, having regard to the representations made by the firm, without taking into account any expectations regarding future distributions of profits or the granting of discretionary additions in respect of an established surplus.

PRU 7.3.72G

In PRU 7.3.71 R (1)(a) firms must take into consideration, for example, a market value adjustment where such an adjustment has been described in representations made to policyholders by the firm. However, any discretionary adjustment, such as a market value adjustment, cannot be included in the amount calculated in PRU 7.3.71 R (1)(b).

## Persistency assumptions

PRU 7.3.73G

PRU 7.3.76 R and PRU 7.3.77 G apply to the valuation of the with-profits insurance liabilities of realistic basis life firms. PRU 7.3.74 R and PRU 7.3.75 G apply to the valuation of all other liabilities.

PRU 7.3.74R

Except as permitted by PRU 7.3.76 R, a firm must not make any allowance in the calculation of the mathematical reserves for the voluntary discontinuance of any contract of insurance if the amount of the mathematical reserves so determined would, as a result, be reduced.

PRU 7.3.75G

The rate of voluntary discontinuance (that is, lapse, surrender or paying up) is often difficult to predict and may be volatile especially in the short term during stressful economic conditions. Depending upon the circumstances and contract terms, voluntary discontinuance may increase or decrease the firm's liability. In effect, PRU 7.3.74 R requires a firm to assume that there will be no voluntary discontinuance if assuming voluntary discontinuance would reduce the liability. This protects against the risk that arises from volatility in the rate of voluntary discontinuance. In addition, there is the risk of assets not being realisable when needed due to the rates of discontinuance exceeding expected levels.

PRU 7.3.76R

A realistic basis life firm may make assumptions about voluntary discontinuance rates in the calculation of the mathematical reserves for its with-profits insurance business provided that those assumptions meet the general requirements for prudent assumptions as set out in PRU 7.3.10 R and PRU 7.3.13 R.

PRU 7.3.77G

The prudential margin in respect of assumptions of voluntary discontinuance should be validated both in relation to recent experience and to variations in future experience that might arise as a result of reasonably foreseeable changes in conditions. In particular, where estimates of experience are being made well into the future, the assumptions should contain margins that take into account the increased risk of adverse experience arising from changed circumstances. Firms should also consider the possibility of anti-selection by policyholders and of variations in persistency experience for different classes and cohorts of business.

## Reinsurance

PRU 7.3.78G

The prospective valuation of future cash flows to determine the amount of the mathematical reserves includes amounts to be received or paid under contracts of reinsurance in respect of long-term insurance business (see PRU 7.3.28 R (4)). This applies even where those cash flows cannot be identified as related to particular long-term insurance contracts (see PRU 7.3.22 R (3)).

PRU 7.3.79R

A firm must value reinsurance cash flows using methods and assumptions which are at least as prudent as the methods and assumptions used to value the underlying contracts of insurance which have been reinsured. In particular:

1. (1)

reinsurance recoveries must not be recognised unless the underlying liabilities to which they relate have also been recognised;

2. (2)

reinsurance cash outflows that are unambiguously linked to the emergence as surplus of margins included in the valuation of existing contracts of insurance or to the exercise by a reinsurer of its rights under a termination clause need not be valued (see PRU 7.3.85 R); and

3. (3)

reinsurance cash inflows that are contingent on factors or conditions other than the insurance risks that are reinsured must not be valued.

PRU 7.3.80G

In valuing reinsurance cash flows, a firm should establish prudent margins for adverse deviation (see PRU 7.3.13 R to PRU 7.3.19 G) including margins in respect of:

1. (1)

any uncertainty as to the amount or timing of amounts to be paid or received; and

2. (2)

the risk of credit default by the reinsurer.

PRU 7.3.81G

In assessing the risk of credit default, the firm should take into account the rules and guidance in PRU 3.2 (Credit risk in insurance).

PRU 7.3.82G

It will not necessarily be appropriate to use the same assumptions in PRU 7.3.79 R as for the underlying contracts. For example, if only a subgroup of the original contracts is reinsured, it may be appropriate to use different mortality rates.

PRU 7.3.83G

Only reinsurance cash inflows that are triggered unambiguously by the insurance risks of the firm that are reinsured may be valued. Reinsurance cash inflows that depend on other contingencies where the outcome does not form part of the valuation basis should not be given credit.

PRU 7.3.84G

Firms should assess the extent of margins in the valuation of the existing contracts of insurance where these provide implicit provision for the reinsurance cash outflows in PRU 7.3.79 R. Where the reinsurance asset exceeds the estimated value of the future surplus under reinsured contracts firms should assess their credit risk exposure to the reinsurer.

PRU 7.3.85R

For the purposes of PRU 7.3.79 R (2), the "link" must be such that a contingent liability to pay or repay the amount to the reinsurer could not arise except when, and to the extent that, the margins in the valuation of the existing contracts of insurance emerge as surplus, or the reinsurer exercises its rights under a termination clause as a result of fraud, misrepresentation, the non-payment of reinsurance premiums by the firm or a failure by the firm to obtain the agreement of the reinsurer to a transfer of business by the firm.

PRU 7.3.86R

For the purposes of PRU 7.3.79 R (2) and PRU 7.3.85 R, future surplus may only be offset against future reinsurance cash outflow in respect of surplus on non-profit insurance contracts and the charges or shareholder transfers arising as surplus from with-profits insurance contracts. Such charges and transfers may only be allowed for to the extent consistent with the regulatory duty of the firm to treat its customers fairly.

PRU 7.3.87G

For the purposes of PRU 7.3.85 R, a contingent liability means a liability that would only arise upon the happening of a particular contingency, even where that contingency is not expected to occur. For example, if the firm has a reinsurance arrangement in force that in the event the firm were wound up would give rise to repayments other than out of surplus emerging, the reinsurance cash outflows should be valued as a liability.

PRU 7.3.88G

PRU 7.3.85 R allows a firm not to value reinsurance cash outflows provided the contingencies in which the reinsurance would require repayment other than out of future surpluses are limited to termination clauses concerning fraud, misrepresentation, non-payment of reinsurance premiums by the firm or a failure by the firm to obtain the agreement of the reinsurer to a transfer of business by the firm.

PRU 7.3.89G

Where the reinsurance cash outflow is payable by a fund or sub-fund that generates such profits, charges or transfers, the firm need make no provision for such payments provided that repayment to the reinsurer is linked unambiguously (as defined in PRU 7.3.85 R) to the emergence of future surplus. Where the profits, charges or transfers arising under a block of business are payable by a fund or sub-fund to another part of the firm then only where the firm has committed to remit such profits, charges or transfers directly to the reinsurer would it be acceptable for no provision for payments to the reinsurer to be made.

PRU 7.3.90R

In PRU 7.3.78 G to PRU 7.3.89 G references to reinsurance and contracts of reinsurance include analogous non-reinsurance financing agreements.

PRU 7.3.91G

In PRU 7.3.78 G to PRU 7.3.89 G references to reinsurance cash outflow include any provision for the reduction in policy liabilities recognised as covered under a contract of reinsurance or for the reduction of any debt to the firm previously created under a contract of reinsurance. In PRU 7.3.90 R analogous non-reinsurance financing agreements include contingent loans, securitisations and any other arrangements giving rise to charges on future surplus arising.