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PRU 7.4 With-profits insurance capital component

Application

PRU 7.4.1R
PRU 7.4.2G

A realistic basis life firm means a firm to which PRU 2.1.15 R applies. The application of PRU 2.1.15 R is set out in PRU 2.1.16 R and PRU 2.1.17 R. 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. The enhanced capital requirement forms part of the capital resources requirement for a realistic basis life firm. The with-profits insurance capital component forms part of the enhanced capital requirement which a realistic basis life firm is required to calculate in accordance with PRU 2.1.34 R.

Purpose

PRU 7.4.3G

This section sets out rules and guidance as to the methods and assumptions to be used in calculating the with-profits insurance capital component.

PRU 7.4.4G

The purpose of the with-profits insurance capital component is to supplement the mathematical reserves so as to ensure that a firm holds adequate financial resources for the conduct of its with-profits insurance business. In particular, capital in excess of the mathematical reserves may be needed to ensure that adequate final bonuses can be awarded to policyholders. That is, adequate in the sense that in setting bonuses payable to policyholders the firm pays due regard to the interests of its policyholders and treats them fairly. The mathematical reserves for a realistic basis life firm are not required to include provision for future annual bonuses or final bonuses (PRU 7.3.9 R).

PRU 7.4.5G

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

Main requirements

PRU 7.4.6R

A firm must calculate the with-profits insurance capital component in accordance with PRU 7.4.7 R.

PRU 7.4.7R

  1. (1)

    The with-profits insurance capital component for a firm is the aggregate of any amounts that:

    1. (a)

      result from the calculations specified in (2) and (3); and

    2. (b)

      are greater than zero.

  2. (2)

    Subject to (3), in relation to each with-profits fund within the firm, the firm must deduct B from A, where:

    1. (a)

      A is the amount of the regulatory excess capital for that fund (see PRU 7.4.23 R); and

    2. (b)

      B is the amount of the realistic excess capital for that fund (see PRU 7.4.32 R).

  3. (3)

    Where a capital instrument that can be included in the firm's capital resources in accordance with PRU 2.2 has been attributed wholly or partly to a with-profits fund and that instrument meets the requirements of PRU 2.2.93 R, the firm must add to the amount calculated under (2) for that fund the result, subject to a minimum of zero, of deducting D from C where:

    1. (a)

      C is the outstanding face amount of the instrument to the extent attributed to the fund; and

    2. (b)

      D is the realistic value of the instrument to the extent attributed to the fund in the single event that determines the risk capital margin under PRU 7.4.43 R.

PRU 7.4.8G

Subordinated debt which is subordinated to policyholder interests (see PRU 2.2.93 R is an example of the sort of capital instrument that may give rise to a component of the WPICC under PRU 7.4.7 R (3). Such instruments are treated as capital under PRU 2.2, subject to the requirements of PRU 2.2.93 R. Under realistic reserving the capital instrument is valued as a realistic liability (PRU 7.4.40 R) and in calculating the risk capital margin such an instrument would be valued at its realistic value in the single event outlined in PRU 7.4.43 R (see also PRU 7.4.162 R). Overall, the effect of PRU 2.2, PRU 7.4.7 R (3) and PRU 7.4.43 R is to enable a firm that obtains subordinated debt to benefit from additional capital resources equal to the face amount of that debt.

PRU 7.4.9G

SUP 4 (Actuaries) sets out the role and responsibilities of the actuarial function and of the with-profits actuary.

  1. (1)

    As part of his duties under SUP 4.3.13 R, the actuary appointed by the firm to perform the actuarial function must calculate the firm's mathematical reserves and, in the context of the calculation of the with-profits insurance capital component, must also:

    1. (a)

      advise the firm's governing body on the methods and assumptions to be used in the calculation of the firm's with-profits insurance capital component;

    2. (b)

      perform that calculation in accordance with the methods and assumptions determined by the firm's governing body; and

    3. (c)

      report to the firm's governing body on the results of that calculation.

  2. (2)

    As part of his duties under SUP 4.3.16 G, the with-profits actuary must advise the firm's governing body on the discretion exercised by the firm. In the context of the calculation of the with-profits insurance capital component, the with-profits actuary must also advise the firm's governing body as to whether the methods and assumptions (including the allowance for management actions) used for that calculation are consistent with the firm's Principles and Practices of Financial Management (PPFM - see COB 6.10 ) and with its regulatory duty to treat its customers fairly.

General

Definitions

PRU 7.4.10R

In this section, real estate means an interest in land, buildings or other immovable property.

PRU 7.4.11R

In this section, the long-term gilt yield is the annualised equivalent of the yield on the 15-year index for United Kingdom Government fixed-interest securities jointly compiled by the Financial Times, the Institute of Actuaries and the Faculty of Actuaries.

PRU 7.4.12R

For the purposes of this section, a firm has an exposure to an asset or liability where the firm's valuation of its assets or liabilities changes when the value of the asset or liability changes.

PRU 7.4.13R

Unless the context otherwise requires, all references (however expressed) in this section to realistic liabilities, or to liabilities which are included in the calculation of realistic liabilities, include discretionary benefits payable by the firm in accordance with the firm's regulatory duty to treat its customers fairly.

PRU 7.4.14G

In this section, any reference to a firm's regulatory duty to treat its customers fairly is a reference to the firm's duty under Principle 6 (Customers' interests). This states that a firm must pay due regard to the interests of its customers and treat them fairly.

PRU 7.4.15G

In this section, any reference to the Principles and Practices of Financial Management (PPFM) is a reference to the requirements in COB 6.10 (Principles and Practices of Financial Management) for firms to establish, maintain and record the principles and practices of financial management according to which the business of its with-profits funds is conducted.

PRU 7.4.16G

The extent to which a firm requires a separate PPFM for each of its with-profits funds will depend on the firm's circumstances and any relevant representations made by the firm to its with-profits policyholders. In this section, any reference to a firm's PPFM refers to the PPFM which relate to the with-profits fund or the with-profits insurance contracts in question.

Record keeping

PRU 7.4.17R

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

  1. (1)

    the methods and assumptions used in making any calculation required for the purposes of this section (and any subsequent changes) and the reasons for their use; and

  2. (2)

    any change in practice and the nature of, reasons for, and effect of, any change in approach with respect to those methods and assumptions.

PRU 7.4.18G

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 7.4.17 R, a period of longer than three years will be appropriate for a firm's long-term insurance business. In determining an appropriate time period, a firm should have regard to:

  1. (1)

    the detailed guidance on record keeping in PRU 1.4.51 G to PRU 1.4.64 G;

  2. (2)

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

  3. (3)

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

PRU 7.4.19R

A firm must also identify in the record required to be kept by PRU 7.4.17 R changes in practice, in particular changes in those items which will or may be significant in relation to the eventual claim values.

PRU 7.4.20G

Some of the changes identified in accordance with PRU 7.4.19 R may have to be notified to the firm's policyholders in accordance with the firm's PPFM.

General principles for allocating aggregate amounts

PRU 7.4.21R

Where any calculation is required under this section which:

  1. (1)

    is to be made in respect of any with-profits fund of a firm; and

  2. (2)

    covers an amount that is otherwise calculated in relation to the firm as a whole;

the firm must make an allocation of that amount as between all of its funds (including funds which are not with-profits funds).

PRU 7.4.22R

In any case where:

  1. (1)

    non-profit insurance contracts are written in any with-profits fund of a firm; and

  2. (2)

    any calculation is required under this section which:

    1. (a)

      is to be made in respect of the regulatory excess capital or realistic excess capital for the fund; and

    2. (b)

      covers an amount that is otherwise calculated or allocated in relation to the fund as a whole;

    the firm must make an allocation of the amount in (2)(b) as between the with-profits insurance contracts and non-profit insurance contracts written in the fund.

Calculation of regulatory excess capital

PRU 7.4.23R

A firm must calculate the regulatory excess capital for each of its with-profits funds by deducting B from A, where:

  1. (1)

    A is the regulatory value of assets of the fund (PRU 7.4.24 R); and

  2. (2)

    B is the sum of:

    1. (a)

      the regulatory value of liabilities of the fund (PRU 7.4.29 R);

    2. (b)

      the long-term insurance capital requirement in respect of the fund's with-profits insurance contracts; and

    3. (c)

      the resilience capital requirement in respect of the fund's with-profits insurance contracts.

Regulatory value of assets

PRU 7.4.24R

  1. (1)

    For the purposes of PRU 7.4.23 R (1), the regulatory value of assets of a with-profits fund is equal to the sum of:

    1. (a)

      the amount of the fund's long-term admissible assets; and

    2. (b)

      the amount of any implicit items allocated to that fund;

    less an amount, representing any non-profit insurance contracts written in that fund, determined in accordance with (2).

  2. (2)

    Where non-profit insurance contracts are written in a with-profits fund, the amount representing those contracts is the sum of:

    1. (a)

      the mathematical reserves in respect of the non-profit insurance contract written in the fund; and

    2. (b)

      the following amounts, to the extent that each of them is covered by the fund's long-term admissible assets:

      1. (i)

        an amount in respect of the non-profit insurance contracts written in the fund which represents an appropriate allocation of the firm's long-term insurance capital requirement; and

      2. (ii)

        an amount in respect of the non-profit insurance contracts written in the fund which represents an appropriate allocation of the firm's resilience capital requirement.

PRU 7.4.25R

For the purpose of determining the value of a fund's long-term admissible assets in accordance with PRU 7.4.24 R (1)(a), no value is to be attributed to debts and claims other than in respect of:

  1. (1)

    amounts that have already fallen due; and

  2. (2)

    tax recoveries and claims against compensation funds to the extent not already offset in the mathematical reserves.

PRU 7.4.26R

In making a determination in accordance with PRU 7.4.24 R (2), a firm must allocate long-term admissible assets of an appropriate nature and term to any non-profit insurance contracts written in the with-profits fund.

PRU 7.4.27G

In calculating the amount of a firm's resilience capital requirement allocated to the non-profit insurance contracts in the with-profits fund, the firm should calculate the amount of resilience capital that would be required if that business were in a stand-alone company owning the assets allocated. The resilience capital requirement for the with-profits insurance business should also be calculated as if it were a stand-alone company. An allocation of the firm's total resilience capital requirement should then be made in a manner that would produce a result materially consistent with an allocation in proportion to the amounts calculated for each part of the business as stand-alone entities.

PRU 7.4.28G

A firm needs to obtain an implicit item waiver from the FSA in order to bring in an amount under PRU 7.4.24 R (1)(b). For guidance on applying for an implicit item waiver in respect of future surpluses relating to with-profits funds see PRU 2 Annex 2. The amount of any implicit item allocated to a with-profits fund may be defined in the terms of any waiver granted.

Regulatory value of liabilities

PRU 7.4.29R

For the purposes of PRU 7.4.23 R (2)(a), the regulatory value of liabilities of a with-profits fund is equal to the sum of:

  1. (1)

    the mathematical reserves, in respect of the fund's with-profits insurance contracts, including the value of any provisions reflecting bonuses allocated at the actuarial valuation date; and

  2. (2)

    the regulatory current liabilities of the fund (see PRU 7.4.30 R).

PRU 7.4.30R

For the purposes of PRU 7.4.29 R (2), the regulatory current liabilities of a with-profits fund are equal to the sum of the following amounts to the extent that they relate to that fund:

  1. (1)

    accounting liabilities (including long-term insurance liabilities which have fallen due before the end of the financial year);

  2. (2)

    liabilities from deposit back arrangements; and

  3. (3)

    any provision for adverse variations (determined in accordance with PRU 4.3.17 R).

PRU 7.4.31G

The amount of regulatory current liabilities for a with-profits fund refers to the sum of the amounts in (1) and (2) in respect of the fund:

  1. (1)

    the amount of 'Total other insurance and non-insurance liabilities'; and

  2. (2)

    the amount of 'Cash bonuses which had not been paid to policyholders prior to the end of the financial year';

as disclosed at lines 49 and 12 respectively of the appropriate Form 14 ('Long-term business liabilities and margins') for that fund as part of the Annual Returns required to be deposited with the FSA under IPRU(INS) rule 9.6(1).

Calculation of realistic excess capital

PRU 7.4.32R

A firm must calculate the realistic excess capital for each of its with-profits funds by deducting B from A, where:

  1. (1)

    A is the realistic value of assets of the fund (see PRU 7.4.33R); and

  2. (2)

    B is the sum of:

    1. (a)

      the realistic value of liabilities of the fund (see PRU 7.4.40 R); and

    2. (b)

      the risk capital margin for the fund (see PRU 7.4.43 R).

Realistic value of assets

PRU 7.4.33R

  1. (1)

    For the purposes of PRU 7.4.32 R (1), the realistic value of assets of a with-profits fund is the sum of:

    1. (a)

      the amount of the fund's regulatory value of assets determined in accordance with PRU 7.4.24 R, but with no value given to any implicit items and excluding the regulatory value of any shares in a related undertaking which carries on long-term insurance business;

    2. (b)

      the amount of the fund's excess admissible assets (see PRU 7.4.36 R);

    3. (c)

      the present value of future profits (or losses) on any non-profit insurance contracts written in the with-profits fund (see PRU 7.4.37 R);

    4. (d)

      the value of any derivative or quasi-derivative held in the fund (see PRU 1.3.11 R to PRU 1.3.30 R) to the extent its value is not reflected in (a), (b) or (c);

    5. (e)

      any amount determined under (2); and

    6. (f)

      the amount of any prepayments made from the fund.

  2. (2)

    Where any equity shares held (directly or indirectly) by a firm (A):

    1. (a)

      are shares in a related undertaking (B) which carries on long-term insurance business; and

    2. (b)

      have been identified by A under PRU 7.4.21 R as long-term insurance assets which are held in the with-profits fund for which the realistic value is to be determined under (1);

    the amount required under (1)(e) is the relevant proportion of the value of all B's equity shares as determined in (3).

  3. (3)

    For the purposes of (2):

    1. (a)

      the relevant proportion is the proportion of the total number of equity shares issued by B which are held (directly or indirectly) by A;

    2. (b)

      the value of all B's equity shares must be taken as D deducted from C, where C is equal to the sum of:

      1. (i)

        the shareholder net assets of B;

      2. (ii)

        any surplus assets in the non-profit funds of B;

      3. (iii)

        any additional amount arising from the excess of the present value of future profits (or losses) on any non-profit insurance contracts written by B (calculated on a basis consistent with PRU 7.4.37 R), excluding any amount arising from business that is written in a with-profits fund, over any present value of future profits (or losses) used in calculating B's regulatory capital requirements and arising from business outside its with-profits funds; and

      4. (iv)

        where B has any with-profits funds, the present value of projected future transfers out of those funds to shareholder funds of B;

      and D is equal to the sum of:

      1. (v)

        the long-term insurance capital requirement in respect of any non-profit insurance contracts written in a non-profit fund of B;

      2. (vi)

        the amount of the resilience capital requirement in respect of any non-profit insurance contracts written in a non-profit fund of B;

      3. (vii)

        any part of the with-profits insurance capital component of B, to the extent that this is not covered from the assets of the with-profits fund from which it arises after deducting from those assets the amount calculated under (iv); and

      4. (viii)

        any assets of B that back its regulatory capital requirements and that are valued in (iii) in the calculation of the present value of future profits of non-profit insurance business written by B.

  4. (4)

    The methods and assumptions used in the calculations under (3)(b)(iii) and (iv) must follow a consistent approach to that set out in PRU 7.4.37 R.

PRU 7.4.34G

In PRU 7.4.33 R (1)(d), where a derivative or quasi-derivative has a positive asset value, credit should be given within the realistic value of assets. If the derivative or quasi-derivative has a negative asset value it should be valued within realistic liabilities as an element of realistic current liabilities (see PRU 7.4.40 R (3)).

PRU 7.4.35G

Where a firm identifies shares in a related undertaking which carries on long-term insurance business as shares held in one of its with-profits funds, PRU 7.4.33 R (1)(e), PRU 7.4.33 R (2) and PRU 7.4.33 R (3) bring in a realistic valuation of the related undertaking equal to its net assets plus the present value of future profits, less its regulatory capital requirements (see PRU 7.4.33 R (3)(v), (vi) and (vii)). Where the related undertaking has taken the present value of future profits arising from its contracts into consideration in covering its regulatory capital requirements (for example, its risk capital margin, under PRU 7.4.45 R (2)(c)), PRU 7.4.33 R (3)(b)(iii) requires a firm to exclude those future profits in valuing the related undertaking. The subtraction of the capital requirements in the calculation provides a straightforward method of allowing for the change in the related undertaking's value in stress conditions, as the value of the related undertaking is not subject to the realistic stress tests of the risk capital margin. In calculating the present value of future profits on non-profit insurance business written in the related undertaking under PRU 7.4.33 R (3)(b)(iii), a firm may value the release of capital requirements as the business runs off (see PRU 7.4.38 G). PRU 7.4.33 R (3)(b)(viii) ensures that any such capital is not double-counted.

PRU 7.4.36R

Excess admissible assets of a with-profits fund means admissible assets which exceed any of the percentage limits referred to in PRU 3.2.22 R.

PRU 7.4.37R

A firm must calculate the present value of future profits (or losses) on non-profit insurance contracts written in the with-profits fund using methodology and assumptions which:

  1. (1)

    are based on current estimates of future experience;

  2. (2)

    involve reasonable (but not excessively prudent) adjustments to reflect risk and uncertainty;

  3. (3)

    allow for a market-consistent valuation of any guarantees or options within the contracts valued;

  4. (4)

    are derived from current market yields;

  5. (5)

    have regard to generally accepted actuarial practice and generally accepted industry standards appropriate for firms carrying on long-term insurance business;

  6. (6)

    are consistent with the allocation, made in accordance with PRU 7.4.22 R, of any aggregate amounts as between the with-profits insurance contracts and the non-profit insurance contracts written in the fund;

  7. (7)

    allow for any tax that would be payable out of the with-profits fund in respect of the contracts valued; and

  8. (8)

    are consistent with the allocation, made in accordance with PRU 7.4.26 R, of long-term admissible assets as between the with-profits insurance contracts and any non-profit insurance contracts written in the fund.

PRU 7.4.38G

In calculating the present value of future profits (or losses) for non-profit insurance business required by PRU 7.4.33 R (1)(c), to the extent that the long-term insurance capital requirement and the resilience capital requirement are covered by the with-profits fund's long-term admissible assets, a firm may take into consideration any release of these items as the relevant policies go off the books.

PRU 7.4.39G

Annuities do not typically fall to be valued on a market-consistent basis under PRU 7.4.37 R (3) as they are not "options and guarantees" as defined for accounting purposes. This is because they do not have "time value" in the option-pricing meaning of that term. However where, atypically, annuities do fall to be valued on a market-consistent basis under PRU 7.4.37 R (3), the discount rate used should be appropriate to the characteristics of the liability, including its illiquidity. The appropriate interest rate, therefore, would not typically be the risk-free rate. Where illiquid assets are used to closely match similar illiquid liabilities, as could be the case in annuities business, it would be appropriate to look at the liquidity premium that is implicit in the market value of the assets as a proxy for the liquidity premium that should be included in a market consistent valuation of the liabilities. However, care should be exercised in doing this. Assets and liabilities are rarely perfectly matched and an appropriate margin needs to be included in the valuation to cover the risk of unexpected mismatch.

Realistic value of liabilities: general

PRU 7.4.40R

For the purposes of PRU 7.4.32 R (2)(a), the realistic value of liabilities of a with-profits fund is the sum of:

  1. (1)

    the with-profits benefits reserve of the fund;

  2. (2)

    the future policy related liabilities of the fund; and

  3. (3)

    the realistic current liabilities of the fund.

PRU 7.4.41G

All liabilities arising under, or in connection with, with-profits insurance contracts written in the fund should be included in the realistic value of liabilities referred to in PRU 7.4.40 R, including those in respect of guarantees and the value of options.

PRU 7.4.42G

Detailed rules and guidance for the calculation of the three elements referred to in PRU 7.4.40 R are contained below in this section:

  1. (1)

    PRU 7.4.116 R to PRU 7.4.135 G refer to the with-profits benefits reserve;

  2. (2)

    PRU 7.4.136 G to PRU 7.4.189 G refer to the future policy related liabilities; and

  3. (3)

    PRU 7.4.190 R and PRU 7.4.191 R refer to the realistic current liabilities.

Risk capital margin

PRU 7.4.43R

  1. (1)

    A firm must calculate a risk capital margin for each of its with-profits funds in accordance with (2) to (6).

  2. (2)

    The firm must identify relevant assets (PRU 7.4.45 R) which, in the most adverse scenario, will have a value (PRU 7.4.46 R) which is equal to the realistic value of liabilities of the fund under that scenario.

  3. (3)

    The most adverse scenario means the single event comprising that combination of the scenarios in PRU 7.4.44 R which gives rise to the largest positive value that results from deducting B from A, where:

    1. (a)

      A is the value of relevant assets which will produce the result described in (2); and

    2. (b)

      B is the realistic value of liabilities of the fund.

  4. (4)

    The risk capital margin for the fund is the result of deducting C from A, where C is the sum of:

    1. (a)

      B; and

    2. (b)

      any amount included within relevant assets under PRU 7.4.45 R (2)(c).

  5. (5)

    In calculating the value of relevant assets for the purpose of determining the most adverse scenario in (3), a firm must not adjust the valuation of any asset taken into consideration under PRU 7.4.33 R (1)(e) (related undertakings carrying on long-term insurance business) or PRU 7.4.45 R (2)(c) (present value of future profits arising from insurance contracts written outside the with-profits fund).

  6. (6)

    In calculating the realistic value of liabilities of a fund under any scenario, a firm is not required to adjust the best estimate provision made under PRU 7.4.190 R (1) in respect of a defined benefits pension scheme in accordance with PRU 7.4.191 R .

PRU 7.4.44R

For the purposes of PRU 7.4.43 R (3), the scenarios are one scenario selected from each of the following:

  1. (1)

    in respect of UK and other assets within PRU 7.4.62 R (1)(a):

    1. (a)

      the range of market risk scenarios identified in accordance with PRU 7.4.68 R (1) (equities);

    2. (b)

      the range of market risk scenarios identified in accordance with PRU 7.4.68 R (2) (real estate); and

    3. (c)

      the range of market risk scenarios identified in accordance with PRU 7.4.68 R (3) (fixed interest securities);

  2. (2)

    in respect of non-UK assets within PRU 7.4.62 R (1)(b):

    1. (a)

      the range of market risk scenarios identified in accordance with PRU 7.4.73 R (1) (equities);

    2. (b)

      the range of market risk scenarios identified in accordance with PRU 7.4.73 R (2) (real estate); and

    3. (c)

      the range of market risk scenarios identified in accordance with PRU 7.4.73 R (3) (fixed interest securities);

  3. (3)

    the range of credit risk scenarios identified in accordance with PRU 7.4.78 R (1) (bond or debt items);

  4. (4)

    the range of credit risk scenarios identified in accordance with PRU 7.4.78 R (2) (reinsurance items or analogous non-reinsurance financing agreements);

  5. (5)

    the range of credit risk scenarios identified in accordance with PRU 7.4.78 R (3) (other items including derivatives and quasi-derivatives); and

  6. (6)

    the persistency risk scenario identified in accordance with PRU 7.4.100R.

PRU 7.4.45R

  1. (1)

    In PRU 7.4.43 R, in relation to a with-profits fund, the relevant assets means a range of assets which meets the following conditions:

    1. (a)

      the range is selected on a basis which is consistent with the firm's regulatory duty to treat its customers fairly;

    2. (b)

      the range must include assets from within the with-profits fund the value of which is greater than or equal to the realistic value of liabilities of the fund;

    3. (c)

      the range is selected in accordance with (2); and

    4. (d)

      no asset of the firm may be allocated to the range of assets identified in respect of more than one with-profits fund.

  2. (2)

    The range of assets must be selected from the assets specified in (a) to (c), in the order specified:

    1. (a)

      assets that have a realistic value under PRU 7.4.33 R;

    2. (b)

      where a firm has selected all the assets within (a), any admissible assets that are not identified as held within the with-profits fund; and

    3. (c)

      where a firm has selected all the assets within (a) and (b), any additional assets.

  3. (3)

    But a firm must not bring any amounts into account under (2)(b) or (2)(c) in respect of any with-profits fund if that would result in the firm exceeding its overall maximum limit (determined according to whether the firm has only one with-profits fund or more than one such fund).

  4. (4)

    A firm exceeds its overall maximum limit for amounts brought into account under (2)(b) where:

    1. (a)

      in the case of a firm with a single with-profits fund, the amount the firm brings into account in respect of that fund;

    2. (b)

      in the case of a firm with two or more with-profits funds, the aggregate of the amounts the firm brings into account in respect of each of those funds;

    exceeds the sum of the firm's shareholder net assets and the surplus assets in the firm's non-profits funds, less any regulatory capital requirements in respect of business written outside its with-profits funds.

  5. (5)

    A firm exceeds its overall maximum limit for amounts brought into account under (2)(c) where:

    1. (a)

      in the case of a firm with a single with-profits fund, the amount the firm brings into account in respect of that fund;

    2. (b)

      in the case of a firm with two or more with-profits funds, the aggregate of the amounts the firm brings into account in respect of each of those funds;

    exceeds 50% of the present value of future profits arising from insurance contracts written by the firm outside its with-profits funds.

PRU 7.4.46R

In valuing the relevant assets identified under PRU 7.4.43 R (2), a firm must use the same methods of valuation as in PRU 7.4.33 R, except that:

  1. (1)

    the value of any admissible assets not identified as held within the with-profits fund (PRU 7.4.45 R (2)(b)) must be as determined under PRU 1.3; and

  2. (2)

    the value of any asset which forms part of the range of assets as a result of PRU 7.4.45 R (2)(c) must be determined on a basis consistent with that described in PRU 7.4.37 R.

PRU 7.4.47G

The purpose of the risk capital margin for a with-profits fund is to cover adverse deviation from:

  1. (1)

    the fund's realistic value of liabilities;

  2. (2)

    the value of assets identified, in accordance with PRU 7.4.43 R (2), to cover the amount in (1) and the fund's risk capital margin;

arising from the effects of market risk, credit risk and persistency risk. Other risks are not explicitly addressed by the risk capital margin.

PRU 7.4.48G

The amount of the risk capital margin calculated by the firm for a with-profits fund will depend on the firm's choice of assets held to cover the fund's realistic value of liabilities and the margin. PRU 7.4.43 R requires the relevant assets to be sufficient, in the most adverse scenario, to cover the realistic value of liabilities in the event that scenario was to arise.

PRU 7.4.49G

PRU 7.4.45 R (2)(c) allows firms to bring the economic value of non-profit insurance business written outside a with-profits fund into the assets available to cover the risk capital margin. To place a prudent limit on the amount of future profits taken into consideration a maximum of 50% of the present value of non-profit insurance business can be taken into the calculation (PRU 7.4.45 R (5)). Where a contract is written in a non-profit fund but the assets arising from that contract are invested in a with-profits fund which is subject to charges for investment management or other services which benefit the non-profit fund, such charges can be taken into consideration in calculating the present value of future profits of the non-profit insurance business. Where a proportion of the present value of future profits on non-profit insurance business written outside a with-profits fund is brought in as an asset, no stress tests apply to this asset (see PRU 7.4.43 R (5)) as the amount taken into consideration is limited to 50% of the total present value.

PRU 7.4.50G

A firm using a stochastic approach in PRU 7.4.169 R (1) should keep recalibration in the post-stress scenarios to the minimum required to reflect any change in the underlying risk-free yields. A firm using the market costs of hedging approach, as in PRU 7.4.169 R (2), may assume in estimating the market cost of hedging in the post-stress scenarios that market volatilities are unchanged.

PRU 7.4.51G

In the scenario tests set out in PRU 7.4.62 R to PRU 7.4.103 G, firms are required to test for worst case scenarios across a range of assumptions. The tests are, with the exception of the credit risk test, two-sided, requiring both increases and decreases in the assumptions. The FSA does not expect a firm to investigate every possible stress, but a firm should be able to demonstrate that it is reasonable to assume that it has successfully identified the single event that determines the risk capital margin for the firm's business, as required by PRU 7.4.43 R (3).

Management actions

PRU 7.4.52R

In calculating the risk capital margin for a with-profits fund, a firm may reflect, in its projections of the value of assets and liabilities under the scenarios in PRU 7.4.44R, the firm's prospective management actions (PRU 7.4.53 R).

PRU 7.4.53R

Prospective management actions refer to the foreseeable actions that would be taken by the firm's management, taking into account:

  1. (1)

    an appropriately realistic period of time for the management actions to take effect; and

  2. (2)

    the firm's PPFM and its regulatory duty to treat its customers fairly.

PRU 7.4.54G

The management actions in PRU 7.4.53 R may include, but are not limited to, changes in future bonus rates, reductions in surrender values, changes in asset dispositions (taking into account the associated selling costs) and changes in the amount of charges deducted from asset shares for with-profits insurance contracts.

PRU 7.4.55G

A firm should use reasonable assumptions in incorporating management actions into its projections of claims such that the mitigating effects of the management actions are not overstated. In modelling management actions, a firm should ensure consistency with its PPFM and take into account its regulatory duty to treat its customers fairly.

PRU 7.4.56G

In accordance with PRU 7.4.17 R, a firm should make and retain a record of the approach used, in particular the nature and effect of anticipated management actions (including, where practicable, the amount by which the actions would serve to reduce the projected values of assets and liabilities).

PRU 7.4.57G

A firm which deducts charges in respect of any adverse experience or cost of capital to with-profits insurance contracts should keep a record under PRU 7.4.17 R of the amount of any such charges to its customers and of how it has ensured their fair treatment.

Policyholder actions

PRU 7.4.58R

In calculating the risk capital margin for a with-profits fund, a firm must reflect, in its projections of the value of assets and liabilities under the scenarios in PRU 7.4.44 R, a realistic assessment of the actions of its policyholders (see PRU 7.4.59 R).

PRU 7.4.59R

Policyholder actions refer to the foreseeable actions that would be taken by the firm's policyholders, taking into account:

  1. (1)

    the experience of the firm in the past; and

  2. (2)

    the changes that may occur in the future if options and guarantees become more valuable to policyholders than in the past.

PRU 7.4.60G

A firm should use realistic assumptions in incorporating policyholder actions into its projections of claims such that any mitigating effects of policyholder actions are not overstated and any exacerbating effects of policyholder actions are not understated. In modelling policyholder actions, a firm should ensure consistency with its PPFM and take into account its regulatory duty to treat its customers fairly in determining the options and information that would be available to policyholders.

PRU 7.4.61G

In calculating the persistency scenario in PRU 7.4.100 R, a firm needs to make assumptions regarding the future termination rates exhibited by policies, at points described in particular in PRU 7.4.101 R. Such assumptions should be realistic. However, the firm must have regard to the economic scenarios being projected. For example, if the value of an option became significantly greater in a future scenario than in the recent past, then the behaviour of policyholders in taking up the option is likely to differ in this future scenario compared with the recent past.

Market risk scenario

PRU 7.4.62R

  1. (1)

    For the purposes of PRU 7.4.44 R, the ranges of market risk scenarios that a firm must assume are:

    1. (a)

      for exposures to UK assets and for exposures to non-UK assets within (2), the ranges of scenarios set out in PRU 7.4.68 R; and

    2. (b)

      for exposures to other non-UK assets, the ranges of scenarios set out in PRU 7.4.73 R.

  2. (2)

    The exposures to non-UK assets within this paragraph are:

    1. (a)

      exposures which do not arise from a significant territory outside the United Kingdom (PRU 7.4.63 R); or

    2. (b)

      exposures which do arise from a significant territory outside the United Kingdom but which represent less than 0.5% of the realistic value of assets of the with-profits fund, measured by market value.

PRU 7.4.63R

For the purposes of this section in relation to a with-profits fund, a significant territory is any country or territory in which more than 2.5% of the fund's realistic value of assets (by market value) are invested.

PRU 7.4.64G

In determining its most adverse scenario, a firm applying PRU 7.4.68 R and PRU 7.4.73 R should consider separately possible movements in UK and non-UK markets. It should not assume that market prices in different markets move in a similar way at the same time. A firm should also allow for the effect of the other components of the single event comprising the combination of scenarios applicable under PRU 7.4.43 R.

PRU 7.4.65G

In relation to the market risk scenarios in PRU 7.4.68 R and PRU 7.4.73 R, the effect of PRU 7.4.52 R and PRU 7.4.58 R is that a firm may reflect management actions and must make a realistic assessment of policyholder actions in projecting the assets and liabilities in its calculation of the risk capital margin for a with-profits fund within the firm. This contrasts with the position for calculating the resilience capital requirement for the firm (PRU 4.2.9 G to PRU 4.2.26 R).

PRU 7.4.66G

In PRU 7.4.62 R to PRU 7.4.76 G, where there is reference to exposure to assets invested in a territory this should be interpreted as follows:

  1. (1)

    for equities, a stock that is listed on a stock market in that territory or, if unlisted, the stock of a company that is incorporated in that territory;

  2. (2)

    for bonds, one that is denominated in the currency of that territory, or issued by an institution incorporated in that territory;

  3. (3)

    for real estate, a property that is located in that territory; and

  4. (4)

    for derivatives, quasi-derivatives and other instruments, one where the assets to which the instrument is exposed are assets invested in that territory.

In PRU 7.4.62 R to PRU 7.4.76 G, a preference share should be subjected to the same stress tests as an equity share.

PRU 7.4.67G

The relevant assets identified under PRU 7.4.43 R (2) to calculate the risk capital margin may, in certain circumstances, include up to 50% of the present value of future profits arising from insurance contracts written by the firm outside its with-profits funds. PRU 7.4.43 R (5) exempts such an asset from the market risk stress tests.

Market risk scenario for exposures to UK assets and certain non-UK assets

PRU 7.4.68R

The range of market risk scenarios referred to in PRU 7.4.62(1)(a) is:

  1. (1)

    a rise or fall in the market value of equities of up to the greater of:

    1. (a)

      10%; and

    2. (b)

      20%, less the equity market adjustment ratio (see PRU 7.4.71 R);

  2. (2)

    a rise or fall in real estate values of up to 12.5%; and

  3. (3)

    a rise or fall in yields on all fixed interest securities of up to 17.5% of the long-term gilt yield.

PRU 7.4.69R

For the purposes of PRU 7.4.68 R, a firm must:

  1. (1)

    assume that yields on equities and real estate remain unchanged from those applicable at market levels before applying each scenario; and

  2. (2)

    model a rise or fall in equity, real estate and fixed interest markets as if the movement occurred instantaneously.

PRU 7.4.70G

For example, where the long-term gilt yield is 6%, a change of 17.5% in that yield would amount to a change of 1.05 percentage points. For the purpose of the scenarios in PRU 7.4.68 R (3), the firm would assume a fall or rise of up to 1.05 percentage points in yields on all fixed interest securities.

Equity market adjustment ratio

PRU 7.4.71R

The equity market adjustment ratio referred to in PRU 7.4.68 R (1)(b) is:

  1. (1)

    if the ratio calculated in (a) and (b) lies between 80% and 100%, the result of 100% less the ratio (expressed as a percentage) of:

    1. (a)

      the current value of the FTSE Actuaries All Share Index; to

    2. (b)

      the average value of the FTSE Actuaries All Share Index over the preceding 90 calendar days;

  2. (2)

    0%, if the ratio calculated in (1)(a) and (b) is more than 100%; and

  3. (3)

    20%, if the ratio calculated in (1)(a) and (b) is less than 80%.

PRU 7.4.72R

In PRU 7.4.71(1)(b), the average value of the FTSE Actuaries All Share Index over any period of 90 calendar days means the arithmetic mean based on levels at the close of business on each of the days in that period on which the London Stock Exchange was open for trading.

Market risk scenario for exposures to other non-UK assets

PRU 7.4.73R

The range of market risk scenarios referred to in PRU 7.4.62 R (1)(b) is:

  1. (1)

    an appropriate rise or fall in the market value of equities listed in that territory (PRU 7.4.75 G), which must be at least equal to the percentage determined in PRU 7.4.68 R (1);

  2. (2)

    a rise or fall in real estate values in that territory of up to 12.5%; and

  3. (3)

    a rise or fall in yields on all fixed interest securities of up to 17.5% of the nearest equivalent (in respect of the method of calculation) of the long-term gilt yield.

PRU 7.4.74R

For the purposes of PRU 7.4.73 R, a firm must:

  1. (1)

    assume that yields on equities and real estate remain unchanged from those applicable at market levels before applying each scenario; and

  2. (2)

    model a rise or fall in equity, real estate and fixed interest markets as if the movement occurred instantaneously.

PRU 7.4.75G

For the purposes of PRU 7.4.73 R (1), an appropriate rise or fall in the market value of equities to which a firm has exposure in a significant territory must be determined having regard to:

  1. (1)

    an appropriate equity market index (or indices) for that territory; and

  2. (2)

    the historical volatility of the equity market index (or indices) selected in (1).

PRU 7.4.76G

For the purpose of PRU 7.4.75 G (1), an appropriate equity market index (or indices) for a territory should be such that:

  1. (1)

    the constituents of the index (or indices) are reasonably representative of the nature of the equities to which the firm is exposed in that territory which are included in the relevant assets identified in accordance with PRU 7.4.43 R (2); and

  2. (2)

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

Credit risk scenarios

General

PRU 7.4.77G

  1. (1)

    The purpose of the credit risk scenarios in PRU 7.4.78 R to PRU 7.4.99 G is to show the financial effect of specified changes in the general credit risk environment on a firm's direct (counterparty) and indirect credit risk exposures. The scenarios apply in relation to corporate bonds, debt, reinsurance and other exposures, including derivatives and quasi-derivatives. This is thus quite separate from any reference to allowance for credit risk in PRU 4.2.

  2. (2)

    In the case of bonds and debts, the scenarios are described in terms of an assumed credit rating dependent on the widening of credit spreads - changes in bond and debt credit spreads will have a direct impact on the value of bond and debt assets. Credit ratings are intended to give an indication of the security of the income and capital payments for a bond - the higher the credit rating, the more secure the payments. The reaction of credit spreads to developments in markets for credit risk varies by credit rating and so the scenarios to be assumed for bonds and debts depend on their ratings. The credit spreads on bonds and debt represent compensation to the investor for the risk of default and downgrade, but also for illiquidity, price volatility and the uncertainty of recovery rates relative to government bonds. Credit spreads on bonds tend to widen during an economic recession to reflect the increased expectations that corporate borrowers may default on their obligations or be subject to rating downgrades.

  3. (3)

    Changes in bond and debt credit spreads will also be indicative of a change in direct counterparty exposure in relation to reinsurance and other exposures including derivatives and quasi-derivatives.

  4. (4)

    In addition, changes in bond and debt credit spreads may indirectly impact on credit exposures, for example by affecting the payments anticipated under credit derivative instruments.

  5. (5)

    A firm will also need to allow for the effect of other components of the single event comprising the combination of scenarios applicable under PRU 7.4.43 R in assessing exposure to credit risk. For example, in the case of an equity put option and a fall in equity market values, the resulting increase in the level of exposure to the firm's counterparty for the option combined with a change in the quality of the counterparty should be allowed for.

PRU 7.4.78R

For the purposes of PRU 7.4.44 R, the range of credit risk scenarios that a firm must assume is:

  1. (1)

    changes in value resulting from an increase in credit spreads by an amount of up to the spread stress determined according to PRU 7.4.84 R in respect of any bond or debt item;

  2. (2)

    changes in value determined according to PRU 7.4.94 R in respect of any reinsurance item or any analogous non-reinsurance financing agreement item; and

  3. (3)

    changes in value determined according to PRU 7.4.98 R for any other item (including any derivative or quasi-derivative).

PRU 7.4.79R

For the purposes of PRU 7.4.78 R, a firm must make appropriate allowance for any loss mitigation techniques to the extent that they are loss mitigation techniques relied on for the purpose of PRU 3.2.8 R in accordance with PRU 3.2.16 R and PRU 3.2.18 R.

PRU 7.4.80G

The change in asset or liability values to be determined in relation to a credit risk scenario for the purposes of PRU 7.4.43 R and PRU 7.4.44 R is the change in value which would arise on the occurrence of the relevant credit risk scenario as a result of bond, debt, reinsurance or other exposures whether or not there is a direct counterparty exposure.

PRU 7.4.81R

Where a bond or a debt item or reinsurance asset is currently in default, it may be ignored by a firm for the purpose of applying PRU 7.4.78 R.

PRU 7.4.82G

Where a bond or a debt item or a reinsurance asset is currently in default and has been specifically provisioned, in accordance with relevant accounting standards, a firm is not required to increase the existing default provisions to reflect a worsening of recovery rates.

PRU 7.4.83R

Where the credit risk scenarios in PRU 7.4.78 R to PRU 7.4.99 G require a firm to assume a change in current credit spread, or a direct change in market value, the firm must not change the risk-free yields used to discount future cash flows in calculating the revised realistic value of liabilities and realistic value of assets (PRU 7.4.43 R (2)) resulting from those credit risk scenarios.

Spread stresses to be assumed for bonds and debt

PRU 7.4.84R

  1. (1)

    In PRU 7.4.78 R (1) the spread stress which a firm must assume for any bond or debt item is:

    1. (a)

      for any bond or debt item issued or guaranteed by an organisation which is in accordance with PRU 7.4.87 R a credit risk scenario exempt organisation in respect of that item, zero basis points; and

    2. (b)

      for any other bond or debt item:

      1. (i)

        Y if the credit rating description of that other bond or debt item determined by reference to PRU 7.4.89 R is not "Highly speculative or very vulnerable"; and

      2. (ii)

        otherwise the larger of Y and Z.

  2. (2)

    For the purpose of (1)(b):

    1. (a)

      Y is the product of the spread factor for that bond or debt item and the square root of S, where:

      1. (i)

        the spread factor for a bond or debt item is the spread factor shown in the final column of Table PRU 7.4.90 R, in the row of that Table corresponding to the credit rating description of the bond or debt item determined for the purpose of this rule by reference to PRU 7.4.89 R; and

      2. (ii)

        subject to (3), S is the current credit spread for a bond or debt item, expressed as a number of basis points, which the firm must determine as the current yield on that bond or debt item in excess of the current gross redemption yield on the government bond most similar to that bond or debt item in terms of currency of denomination and equivalent term; and

    2. (b)

      Z is the change in credit spread expressed as a number of basis points that would result in the current market value of the bond or debt falling by 5%.

  3. (3)

    Where, for the purposes of (2)(a)(ii), there is no suitable government bond, the firm must use its best estimate of the gross redemption yield that would apply for a notional government bond similar to the bond or debt item in terms of currency of denomination and equivalent term.

PRU 7.4.85R

For the purpose of PRU 7.4.84 R (1)(a), a guarantee must be direct, explicit, unconditional and irrevocable.

PRU 7.4.86G

  1. (1)

    As an example, a bond item has the credit rating description "exceptional or extremely strong" and currently yields 49 basis points in excess of the most similar government bond. The spread factor for that bond item is 3.00 by reference to Table PRU 7.4.90 R. Since S is 49, the square root of S is 7 and the spread stress for that item is 3 times 7, that is, 21 basis points. The firm must consider the impact of an increase in spreads by up to 21 basis points for that item.

  2. (2)

    As a further example, a bond item has the credit rating description "highly speculative or very vulnerable". For this bond, S is 400, being the current spread for that bond expressed as a number of basis points. The spread factor for the bond is 24.00. So the firm must consider the impact of an increase in spreads by up to 24.00 times 20 i.e. 480 basis points for that item. The bond is however of short duration and the reduction in market value resulting from an additional spread of 480 basis points is less than 5 per cent of its current market value. A 5 per cent reduction in its market value would result from a spread widening of 525 basis points. The firm must consider the impact of an increase in spreads by up to 525 basis points for that item by virtue of its credit rating description.

  3. (3)

    The calculation of the credit spread on commercial floating rate notes warrants particular consideration. Suppose, for example, that a notional floating rate note guaranteed by the UK government would have a market consistent price of X. This price can be estimated based on an assumed distribution of future payments under the floating rate note, and the current forward gilt curve. Suppose further that the market price of the commercial floating rate note is Y, where Y is less than X. A firm could calculate what parallel upward shift in the forward gilt curve would result in the notional government-backed floating rate note having a market price of Y for an unchanged assumed distribution of future payments. The size of the resulting shift could then be taken as the credit spread on the commercial floating rate note.

  4. (4)

    In arriving at the estimated gross redemption yield in PRU 7.4.84 R (3), the firm may have regard to any appropriate swap rates for the currency of denomination of the bond or debt item, adjusted to take appropriate account of observed differences between swap rates and the yields on government bonds.

PRU 7.4.87R

For the purposes of this section:

  1. (1)

    an organisation is a credit risk scenario exempt organisation in respect of an item if the organisation is:

    1. (a)

      the European Central Bank; or

    2. (b)

      any central government or central bank which, in relation to that item, satisfies the conditions in (2); or

    3. (c)

      a multilateral development bank which is listed in (3); or

    4. (d)

      an international organisation which is listed in (4);

  2. (2)

    the conditions in (1)(b) are that, for any claim against the central government or central bank denominated in the currency in which the item is denominated:

    1. (a)

      a credit rating is available from at least one listed rating agency nominated in accordance with PRU 7.4.92 R; and

    2. (b)

      the credit rating description in the first column of Table PRU 7.4.90 R corresponding to the lowest such credit rating is either "exceptionally or extremely strong" or "very strong";

  3. (3)

    for the purposes of (1)(c) the listed multilateral development banks are:

    1. (a)

      the International Bank for Reconstruction and Development;

    2. (b)

      the International Finance Corporation;

    3. (c)

      the Inter-American Development Bank;

    4. (d)

      the Asian Development Bank;

    5. (e)

      the African Development Bank;

    6. (f)

      the Council of Europe Development Bank;

    7. (g)

      the Nordic Investment Bank;

    8. (h)

      the Caribbean Development Bank;

    9. (i)

      the European Bank for Reconstruction and Development;

    10. (j)

      the European Investment Bank;

    11. (k)

      the European Investment Fund; and

    12. (l)

      the Multilateral Investment Guarantee Agency;

  4. (4)

    for the purposes of (1)(d) the listed international organisations are:

    1. (a)

      the European Community;

    2. (b)

      the International Monetary Fund; and

    3. (c)

      the Bank for International Settlements.

PRU 7.4.88G

Under PRU 7.4.87 R (2), a firm needs to take account of the currency in which the claim is denominated when it is considering claims on or guaranteed by a central government or central bank. It is possible, for example, that a given central bank would be a credit risk scenario exempt organisation in respect of claims on it denominated in its domestic currency, while not being a credit risk scenario exempt organisation in respect of claims on it denominated in a currency other than its domestic currency - the central government or central bank may have been assigned different credit assessments depending on the currency in which the claim on it is denominated.

PRU 7.4.89R

  1. (1)

    For the purposes of this section, the credit rating description of a bond or debt item is to be determined in accordance with (2) and (3).

  2. (2)

    If the item has at least one credit rating nominated in accordance with PRU 7.4.92 R ("a rated item"), its credit rating description is:

    1. (a)

      where it has only one nominated credit rating, the general description given in the first column of Table PRU 7.4.90 R corresponding to that rating; or

    2. (b)

      where it has two or more nominated credit ratings and the two highest nominated ratings fall within the same general description given in the first column of that Table, that description; or

    3. (c)

      where it has two or more nominated credit ratings and the two highest nominated ratings do not fall within the same general description given in the first column of that Table, the second highest of those two descriptions.

  3. (3)

    If the item is not a rated item, its credit rating description is the general description given in the first column of Table PRU 7.4.90 R that most closely corresponds to the firm's own assessment of the item's credit quality.

  4. (4)

    An assessment under (3) must be made by the firm for the purposes of the credit risk scenario having due regard to the seniority of the bond or debt and the credit quality of the bond or debt issuer.

PRU 7.4.90R

Table : Listed rating agencies, credit rating descriptions, spread factors

Credit Rating Description

Listed rating agencies

Spread Factor

A.M. Best Company

Fitch Ratings

Moody's Investors Service

Standard & Poor's Corporation

Exceptional or extremely strong

aaa

AAA

Aaa

AAA

3.00

Very strong

aa

AA

Aa

AA

5.25

Strong

a

A

A

A

6.75

Adequate

bbb

BBB

Baa

BBB

9.25

Speculative or less vulnerable

bb

BB

Ba

BB

15.00

Very speculative or more vulnerable

B

B

B

B

24.00

Highly speculative or very vulnerable

Below B

Below B

Below B

Below B

24.00

PRU 7.4.91G

Where listed rating agencies provide ratings by sub-category then all ratings should be allocated to the main ratings category (e.g. ratings sub-category A+ or A- would be allocated to the assigned ratings category "Strong").

PRU 7.4.92R

For the purposes of PRU 7.4.87 R and PRU 7.4.89 R, a firm may, subject to (1) to (5), nominate for use credit ratings produced by one or more of the rating agencies listed in PRU 7.4.93 R:

  1. (1)

    if the firm decides to nominate for use for an item the credit rating produced by one or more rating agencies, it must do so consistently for all similar items;

  2. (2)

    the firm must use credit ratings in a continuous and consistent way over time;

  3. (3)

    the firm must nominate for use only credit ratings that take into account both principal and interest;

  4. (4)

    if the firm nominates for use credit ratings produced by one of the listed rating agencies then the firm must use solicited credit ratings produced by that listed rating agency; and

  5. (5)

    the firm may nominate for use unsolicited credit ratings produced by one or more of the listed rating agencies except where there are reasonable grounds for believing that any unsolicited credit ratings produced by the agency are used so as to obtain inappropriate advantages in the relationship with rated parties.

PRU 7.4.93R

In this section, a listed rating agency is:

  1. (1)

    A.M. Best Company; or

  2. (2)

    Fitch Ratings; or

  3. (3)

    Moody's Investors Service; or

  4. (4)

    Standard & Poor's Corporation.

Credit risk scenario for reinsurance

PRU 7.4.94R

  1. (1)

    The contracts of reinsurance or analogous non-reinsurance financing agreements to which PRU 7.4.78 R (2) applies are those:

    1. (a)

      into which the firm has entered;

    2. (b)

      which represent an economic asset under the single event applicable under PRU 7.4.43 R (3); and

    3. (c)

      which are material (individually or in aggregate).

  2. (2)

    For the purposes of (1), no account is to be taken of reinsurance or analogous non-reinsurance financing arrangements between undertakings in the same group where:

    1. (a)

      the ceding and accepting undertakings are regulated by the FSA or a regulatory body in a designated State or territory for insurance (including reinsurance);

    2. (b)

      no subsequent cessions of the ceded risk which are material (individually or in aggregate) are made to subsequent accepting undertakings by accepting undertakings (including subsequent accepting undertakings) other than to subsequent accepting undertakings which are in the same group; and

    3. (c)

      for any subsequent cession or cessions of the ceded risk which are material (individually or in aggregate) each of the ceding and accepting undertakings (including subsequent accepting undertakings) is regulated by the FSA or a regulatory body in a designated State or territory for insurance (including reinsurance).

  3. (3)

    The change in value which a firm must determine for a contract of reinsurance or an analogous non-reinsurance financing agreement is the firm's best estimate of the change in realistic value which would result from changes in credit risk market conditions consistent, subject to (4), with the changes in credit spreads determined in accordance with PRU 7.4.78 R (1).

  4. (4)

    For the purpose of (3), 5% should be replaced by 10% in PRU 7.4.84 R (2)(b).

PRU 7.4.95G

  1. (1)

    Reinsurance and analogous non-reinsurance financing agreements entered into by the firm, either with or acting as a reinsurer, must be included within the scope of the scenario. The combined rights and obligations under a contract of reinsurance or an analogous non-reinsurance financing agreement may represent an economic asset or liability. The value placed by the firm on the reinsurance item or non-reinsurance financing item should allow for a realistic assessment of the risks transferred and the risks of counterparty default associated with the item. In the case of analogous non-reinsurance financing agreements, references to terms such as "reinsurer", "ceding undertakings" and "accepting undertakings" include undertakings which by analogy are reinsurers, ceding or accepting undertakings. Analogous non-reinsurance financing agreements include contingent loans, securitisations and any other arrangements giving rise to charges on future surplus arising.

  2. (2)

    In assessing values in accordance with PRU 7.4.94 R, a firm may consider it appropriate to determine values by drawing an analogy with the approach in respect of bond and debt items set out in PRU 7.4.84 R. (This might be the case if, in economic terms, the item being valued sufficiently resembles a bond or debt item - an alternative approach might otherwise be preferred). If the firm does consider it appropriate to draw an analogy, the "credit spread" assumed should be consistent with the assumed default probabilities and the values placed on the reinsurance asset for the purposes of determining the realistic values of assets and liabilities. A firm may regard it as appropriate to have regard to any financial strength ratings applicable to the reinsurer, but if so should apply the same principles set out in PRU 7.4.92 R for the nomination of financial strength ratings. Table PRU 7.4.97 G provides guidance as to the allocation of spread factors which a firm may, by analogy, deem appropriate to apply. Appropriate allowance should be made for any change in the extent of the counterparty exposure under the assumed scenario.

  3. (3)

    The changes in credit risk spreads determined for bond and debt items in accordance with PRU 7.4.78 R (1) are required to result in a reduction in market value for some items of 5% of their current value through the operation of PRU 7.4.84 R (2)(b). For reinsurance contracts and analogous non-reinsurance financing agreements, determining the change in value by reference to PRU 7.4.94 R (3) requires a firm to consider the possibility of counterparty default in changed credit risk market conditions. Where in the changed credit risk market conditions assumed to apply the firm's assessment of the counterparty risk would result in the asset being considered equivalent to "Highly speculative or very vulnerable", the reduction in value required is at least 10% of its current value. PRU 7.4.94 R (4) relates to this requirement.

PRU 7.4.96G

A financial strength rating of a reinsurer refers to a current assessment of the financial security characteristics of the reinsurer with respect to its ability to pay claims under its reinsurance contracts and treaties in accordance with their terms.

PRU 7.4.97G

Table: Listed rating agencies, financial strength descriptions and spread factors

Financial Strength Description

A.M. Best Company

Fitch Ratings

Moody's Investors Service

Standard & Poor's Corporation

Spread Factor

Superior, extremely strong

A++

AAA

Aaa

AAA

3.00

Superior, very strong

A+

AA

Aa

AA

5.25

Excellent or strong

A, A-

A

A

A

6.75

Good

B++,B+

BBB

Baa

BBB

9.25

Fair, marginal

B, B-

BB

Ba

BB

15.00

Marginal, weak

C++,C+

B

B

B

24.00

Unrated or very weak

Unrated or below C++,C+

Unrated or below B

Unrated or below B

Unrated or below B

24.00

Credit risk scenario for other exposures (including any derivative or quasi-derivative)

PRU 7.4.98R

For the purposes of PRU 7.4.78 R (3), the change in value which must be determined for any other item (including any derivative or quasi-derivative) which represents an economic asset under the single event applicable under PRU 7.4.43 R (3) is the firm's best estimate of the change in the realistic value of that item which would result from changes in credit risk market conditions consistent with the changes in credit spreads determined in accordance with PRU 7.4.78 R (1) and the changes in value determined in accordance with PRU 7.4.78 R (2).

PRU 7.4.99G

In applying PRU 7.4.98 R, a firm should assess the total impact on the value of the item resulting from the assumed changed credit risk market conditions. The total change in value may result from the interaction of a number of separate influences. For example, a widening of credit spreads may imply an impact on the amount exposed to counterparty default as well as on the likelihood of that default. Each factor influencing the change in value needs separate consideration. It should be assumed, both for determining amounts exposed to counterparty default and the likelihood of such default that there will be no change in the likelihood of default in relation to an item issued by or guaranteed by an organisation which is in respect of that item a credit risk scenario exempt organisation (PRU 7.4.87 R). PRU 7.4.77 G (5) is also relevant in this context.

Persistency risk scenario

PRU 7.4.100R

For the purposes of the persistency risk scenario in PRU 7.4.44 R (6), a firm must allow for the effects of an increase or a decrease in persistency experience of its with-profits insurance contract by adjusting the termination rates in each year of projection by 32.5% of the termination rates assumed in the calculation of the realistic value of liabilities in PRU 7.4.40 R.

PRU 7.4.101R

The termination rates referred to in PRU 7.4.100 R are the rates of termination (including the paying-up of policies, but excluding deaths, maturities and retirements) other than on dates specified by the firm where:

  1. (1)

    a guaranteed amount applies as the minimum amount which will be paid on claim; or

  2. (2)

    any payments to the policyholder cannot be reduced at the discretion of the firm by its applying a market value adjustment.

PRU 7.4.102R

For the purposes of PRU 7.4.100 R, the increase or decrease in termination rates must be applied to the projection of terminations up to policy guarantee dates and between policy guarantee dates, but not to the assumptions as to the proportion of policyholders taking up the guarantees at policy guarantee dates.

PRU 7.4.103G

PRU 7.4.100 R to PRU 7.4.102 R require firms to apply a persistency stress test to the realistic value of liabilities. Where a firm brings the present value of non-profit insurance business in a with-profits fund into the calculation of the realistic value of assets (see PRU 7.4.33R) there is no requirement to stress this asset for changes in persistency assumptions.

Realistic value of liabilities: detailed provisions

PRU 7.4.104G

PRU 7.4.40 R sets out the three elements comprising the realistic value of liabilities for a with-profits fund. The remainder of this section contains general rules and guidance on determining the realistic value of liabilities plus further detail relating to each of those elements separately, as follows:

  1. (1)

    general rules and guidance in PRU 7.4.105 R to PRU 7.4.115 G;

  2. (2)

    with-profits benefits reserve in PRU 7.4.116 R to PRU 7.4.135 G;

  3. (3)

    future policy related liabilities in PRU 7.4.136 G to PRU 7.4.189 G; and

  4. (4)

    realistic current liabilitiesin PRU 7.4.190 R and PRU 7.4.191 R.

Methods and assumptions: general

PRU 7.4.105R

In calculating the realistic value of liabilities for a with-profits fund, a firm must use methods and assumptions which:

  1. (1)

    are appropriate to the business of the firm;

  2. (2)

    are consistent from year to year without arbitrary changes (that is, changes without adequate reasons);

  3. (3)

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

  4. (4)

    make full provision for tax payable out of the with-profits fund, based on current legislation and practice, together with any known future changes, and on a consistent basis with the other methods and assumptions used;

  5. (5)

    take into account discretionary benefits which are at least equal to, and charges which are no more than, the levels required for the firm to fulfil its regulatory duty to treat its customers fairly;

  6. (6)

    take into account prospective management actions (PRU 7.4.53 R) and policyholder actions (PRU 7.4.59 R);

  7. (7)

    provide for shareholder transfers out of the with-profits fund as a liability of the fund;

  8. (8)

    have regard to generally accepted actuarial practice; and

  9. (9)

    are consistent with the firm's PPFM.

PRU 7.4.106G

More specific rules and guidance are set out below on some aspects of the methods and assumptions to be used in calculating the realistic value of liabilities for a with-profits fund. In contrast to the mathematical reserves requirements in PRU 7.3.10 R (4) and PRU 7.3.13 R, there is no requirement to include margins for adverse deviation of relevant factors in calculating the realistic value of liabilities. Assumptions need be no more prudent than is necessary to achieve a best estimate, taking into account the firm's PPFM and its regulatory duty to treat its customers fairly. Where there is no requirement for a PPFM, for example non-UK business, a firm should use assumptions that are consistent with the firm's documented approach to treating its customers fairly. A firm may judge that a margin should be included in its calculations to avoid an understatement of the realistic value of liabilities as a result of uncertainty, for example, either in its method or in its data.

PRU 7.4.107G

The amount and timing of tax charges affect the amount of assets available to meet policyholder liabilities. PRU 7.4.105 R (4) requires firms to provide fully for all tax payable out of the with-profits fund on a basis consistent with the other assumptions and methods used in deriving the realistic balance sheet. So, for example, all projections which underlie the realistic valuation of assets or liabilities must allow for taxation. The approach adopted should not give any credit for any reduction in tax deriving from future expenses or deficits which is attributable to future new business. For assets backing capital requirements it is not necessary to take into consideration future tax charges on investment income generated by those assets. However, firms should consider this aspect in their capital planning.

PRU 7.4.108G

PRU 7.4.105 R (7) requires firms to provide fully for shareholder transfers. Such transfers do not therefore count as capital in the with-profits fund. However, a firm may apply under section 148 of the Act for a waiver from this requirement. In exercising its discretion under section 148 of the Act, the FSA will have regard (among other factors) to whether a firm has put in place undertakings satisfactory to the FSA, including that future transfers will not be paid out of the firm by way of dividend.

Valuation of contracts: General

PRU 7.4.109R

  1. (1)

    A firm must determine the amount of the with-profits benefits reserve or the future policy related liabilities for a with-profits fund by carrying out a separate calculation in relation to each with-profits insurance contract or for each group of similar contracts.

  2. (2)

    Appropriate approximations or generalisations may be made where they are likely to provide the same, or a higher, result than a separate calculation for each contract.

  3. (3)

    A firm must set up additional reserves on an aggregated basis for general risks which are not specific to individual contracts or a group of similar contacts where the firm considers the realistic value of liabilities may otherwise be understated.

PRU 7.4.110R

For the purpose of PRU 7.4.109 R (1), a group of similar contracts is such that the conditions in PRU 7.4.109 R (2) are satisfied.

PRU 7.4.111G

Where a firm has grouped individual contracts for the purpose of calculating the mathematical reserves for a with-profits fund (in accordance with PRU 7.3.22 R), the firm is not required to use the same grouping of contracts in calculating the with-profits benefits reserve or future policy related liabilities for that fund.

PRU 7.4.112G

In contrast to PRU 7.3.24 R for the mathematical reserves, treating individual contracts as an asset is not prohibited if, and to the extent that, this treatment does not conflict with a firm's regulatory duty to treat its customers fairly.

PRU 7.4.113G

In calculating the with-profits benefits reserve, an overall (grouped or pooled) approach may be appropriate under either of the two methods set out in PRU 7.4.116 R. In particular, the calculation of aggregate retrospective reserves (see PRU 7.4.118 R) and the projection of future cash flows (see PRU 7.4.128 R) based on suitable specimen policies is permitted.

PRU 7.4.114G

In calculating the future policy related liabilities, the grouping of policies for valuing the costs of guarantees, options or smoothing, and their representation by representative policies, is acceptable provided the firm can demonstrate that the grouping of policies does not materially misrepresent the underlying exposure and does not significantly misstate the costs. A firm should exercise care in grouping policies in order to ensure that the risk exposure is not inappropriately distorted by, for example, forming groups containing policies with guarantees that are "in the money" and policies with guarantees well "out of the money". A firm should also have regard to the effects of policyholder behaviour over time on the spread of the outstanding guarantees or options.

PRU 7.4.115G

Where a firm groups similar policies for the purpose of calculating the with-profits benefits reserve or the future policy related liabilities, the firm should carry out sufficient validation to be reasonably sure that the grouping of policies has not resulted in the loss of any significant attributes of the portfolio being valued.

With-profits benefits reserve

PRU 7.4.116R

A firm must calculate a with-profits benefits reserve for a with-profits fund using either:

  1. (1)

    a retrospective calculation under PRU 7.4.118 R (the retrospective method); or

  2. (2)

    a prospective calculation under PRU 7.4.128 R of all future cash flows expected to arise under, or in respect of, each of the with-profits insurance contracts written in that fund (the prospective method).

PRU 7.4.117R

Subject to PRU 7.4.105 R (2), a firm may use different methods under PRU 7.4.116 R for different types or generations of with-profits insurance contracts.

Retrospective method

PRU 7.4.118R

In the retrospective method of calculating a with-profits benefits reserve, a firm must calculate either the aggregate of the retrospective reserves in respect of each with-profits insurance contract or, to the extent permitted by PRU 7.4.109 R and PRU 7.4.110 R, the total retrospective reserve in respect of each group of with-profits insurance contracts.

PRU 7.4.119R

In calculating the retrospective reserve for a with-profits insurance contract, or the total retrospective reserve in respect of a group of with-profits insurance contracts, a firm must take account of at least the following:

  1. (1)

    premiums received from the policyholder;

  2. (2)

    any expenses incurred or charges made (including commissions);

  3. (3)

    any partial benefits paid or due;

  4. (4)

    any investment income on, and any increases (or decreases) in, asset values;

  5. (5)

    any tax paid or payable;

  6. (6)

    any amounts received (or paid) under contracts of reinsurance or analogous non-reinsurance financing agreements, where relevant to retrospective reserves;

  7. (7)

    any shareholder transfers and any associated tax paid or payable; and

  8. (8)

    any permanent enhancements to (or deductions from) the retrospective reserves made by the firm.

PRU 7.4.120G

In taking account of amounts in PRU 7.4.119 R (6), due regard should be had to the specific details of each relevant contract of reinsurance or analogous non-reinsurance financing agreement and the relationship between the amounts received (or paid) and the value of the benefit granted (or received) under the arrangement. This should take into consideration, for example, the risk of default and differences in the firm's realistic assessment of the risks transferred and the contractual terms for such transfer of risk. Analogous non-reinsurance financing agreements include contingent loans, securitisations and any other arrangements giving rise to charges on future surplus arising.

PRU 7.4.121G

Where allowance is made for shareholder transfers, this should be in respect of the accrued bonus entitlement reflected in the retrospective reserve. This would include both annual bonuses already declared and accrued final bonus. However, shareholder transfers in respect of surplus yet to be credited to retrospective reserves should not be charged to those reserves until the corresponding surplus is credited.

PRU 7.4.122R

In calculating retrospective reserves, a firm must have regard to its regulatory duty to treat its customers fairly and must ensure that its approach is consistent with its Principles and Practices of Financial Management.

PRU 7.4.123R

In calculating retrospective reserves, a firm must ensure its treatment of past cash flows, and of any future cash flows, is consistent with those cash flows valued in its prospective calculation of the future policy related liabilities for that fund in accordance with the rules in PRU 7.4.136 G to PRU 7.4.189 G.

PRU 7.4.124G

An example of PRU 7.4.123 R concerns future shareholder transfers. A firm must make adequate provision for future shareholder transfers within the future policy related liabilities (see PRU 7.4.165 R). The basis of provisioning needs to be consistent with the amounts accrued within retrospective reserves and the amounts already transferred out of the with-profits fund.

PRU 7.4.125G

Another example of the application of PRU 7.4.123 R relates to the reference in PRU 7.4.119 R (8) to past permanent enhancements to (or deductions from) retrospective reserves made by firms. This item may include past miscellaneous surplus (or losses) which have been credited to (or debited from) retrospective reserves. Any other enhancements (or deductions) made on a temporary basis and any future surplus (or losses) that firms intend to credit to (or debit from) retrospective reserves should be included under the future policy related liabilities (see PRU 7.4.137 R).

PRU 7.4.126G

Firms characteristically use a range of calculation methods to determine retrospective reserves. A firm's definition and calculation of retrospective reserves will depend on a number of factors. These include: the firm's practice; its administration and accounting systems; the extent of its historical records; and the composition of its with-profits portfolio. The rules and guidance for the retrospective method are drawn up to be sufficiently flexible to accommodate the diversity of calculation methods used by firms, rather than to enforce any particular method of calculation of retrospective reserves. PRU 7.4.119 R simply sets minimum standards that all retrospective methods must meet.

PRU 7.4.127G

For the purposes of PRU 7.4.119 R (2) and PRU 7.4.128 R (2), the phrases 'charges made' or 'charges to be made' refer to circumstances where types of risk (such as mortality risk, longevity risk and investment risk) are met by the firm or with-profits fund in return for a charge deducted by the firm from the with-profits benefits reserve.

Prospective method

PRU 7.4.128R

In the prospective method of calculating a with-profits benefits reserve, a firm must take account of at least the following cash flows:

  1. (1)

    future premiums;

  2. (2)

    expenses to be incurred or charges to be made, including commissions;

  3. (3)

    benefits payable (PRU 7.4.129 R);

  4. (4)

    tax payable;

  5. (5)

    any amounts to be received (or paid) under contracts of reinsurance or analogous non-reinsurance financing agreements, where relevant to with-profits insurance contracts being valued; and

  6. (6)

    shareholder transfers.

PRU 7.4.129R

For the purposes of PRU 7.4.128 R (3), benefits payable include:

  1. (1)

    all guaranteed benefits, including guaranteed amounts payable on death and maturity, guaranteed surrender values and paid-up values;

  2. (2)

    vested, declared and allotted bonuses to which policyholders are entitled; and

  3. (3)

    future annual and final bonuses at least equal to the levels required for the firm to fulfil its regulatory duty to treat its customers fairly.

PRU 7.4.130R

A firm must value the cash flows listed in PRU 7.4.128 R using best estimate assumptions of future experience, having regard to generally accepted actuarial practice and taking into account the firm's PPFM and its regulatory duty to treat its customers fairly.

PRU 7.4.131G

The prospective method sets the with-profits benefits reserve at the net present value of future cash flows listed in PRU 7.4.128 R.

PRU 7.4.132G

In contrast to PRU 7.3.10 R (4) and PRU 7.3.13 R relating to the methods and assumptions used to value the mathematical reserves, there is no requirement to value future cash flows using assumptions that include margins for adverse deviation. Also there are no detailed rules as to the future yields on assets, discount rates, premium levels, expenses, tax, mortality, morbidity, persistency and reinsurance. A firm should make its own assessment as to the amount of these future cash flows including bonuses and discretionary surrender or transfer values. A firm should make a realistic assessment of longevity risk and asset default risk (including default risk arising under contracts of reinsurance or analogous non-reinsurance financing agreements) within the best estimate assumptions of future experience required by PRU 7.4.130 R.

PRU 7.4.133G

In valuing the future cash flows listed in PRU 7.4.128 R, the firm should use a projection term which is long enough to capture all material cash flows arising from the contract or groups of contracts being valued. If the projection term does not extend to the term of the last policy, the firm should check that the shorter projection term does not significantly affect the results.

PRU 7.4.134R

Where a firm expects to pay additional benefits that are not included in the cash flows listed in PRU 7.4.128 R, it must make adequate provision for these benefits in calculating the future policy related liabilities in accordance with the rules in PRU 7.4.136 G to PRU 7.4.189 G.

PRU 7.4.135G

The prospective assessment of the with-profits benefits reserve will usually be on a deterministic basis. A firm will have to make further provision in the future policy-related liabilities for, for example, the costs of potential asset fluctuations or policy options.

Future policy related liabilities

Overview of liabilities

PRU 7.4.136G

PRU 7.4.137 R lists the future policy related liabilities for a with-profits fund that form part of a firm's realistic value of liabilities in PRU 7.4.40 R. Detailed rules and guidance relating to particular types of liability and asset are set out in PRU 7.4.139 R to PRU 7.4.168 G. These are followed by rules and guidance that deal with certain aspects of several liabilities (that is, liabilities relating to guarantees, options and smoothing):

  1. (1)

    PRU 7.4.169 R to PRU 7.4.186 G refer to valuing the costs of guarantees, options and smoothing; and

  2. (2)

    PRU 7.4.187 R to PRU 7.4.189 G refer to the treatment of surplus on guarantees, options and smoothing.

PRU 7.4.137R

The future policy related liabilities for a with-profits fund are equal to the sum of amounts, as they relate to that fund, in respect of (1) to (11) to the extent each is valued as a liability less the sum of amounts, as they relate to that fund, in respect of (1) to (11) to the extent each is valued as an asset:

  1. (1)

    past miscellaneous surplus (or deficit) planned to be attributed to the with-profits benefits reserve (see PRU 7.4.139 R);

  2. (2)

    planned enhancements to the with-profits benefits reserve (see PRU 7.4.141 R);

  3. (3)

    planned deductions for the costs of guarantees, options and smoothing from the with-profits benefits reserve (see PRU 7.4.144 R);

  4. (4)

    planned deductions for other costs deemed chargeable to the with-profits benefits reserve (see PRU 7.4.146 R);

  5. (5)

    future costs of contractual guarantees (other than financial options) (see PRU 7.4.148 R);

  6. (6)

    future costs of non-contractual commitments (see PRU 7.4.154 R);

  7. (7)

    future costs of financial options (see PRU 7.4.156 G);

  8. (8)

    future costs of smoothing (see PRU 7.4.158 R);

  9. (9)

    financing costs (see PRU 7.4.162 R);

  10. (10)

    any other further liabilities required for the firm to fulfil its regulatory duty to treat its customers fairly; and

  11. (11)

    other long-term insurance liabilities (see PRU 7.4.165 R).

PRU 7.4.138G

Some of the elements of the calculation set out in PRU 7.4.137 R may have already been taken into consideration in the calculation of the with-profits benefits reserve, either under the retrospective method (see PRU 7.4.118 R onwards) or the prospective method (see PRU 7.4.128 R onwards). Where this is the case, the adjustments made under PRU 7.4.137 R should be such that no double-counting arises.

Past miscellaneous surplus (or deficit) planned to be attributed to the with-profits benefits reserve

PRU 7.4.139R

In calculating the future policy related liabilities for a with-profits fund, a firm must allow for past miscellaneous surplus (or deficit) which it intends to attribute to the with-profits benefits reserve for that fund but which has not yet been permanently credited to (or debited from) the with-profits benefits reserve for that fund.

PRU 7.4.140G

Past miscellaneous surplus (or deficit) already permanently credited to (or debited from) the with-profits benefits reserve will have been included in the calculation of the with-profits benefits reserve in accordance with PRU 7.4.119 R (8).

Planned enhancements to the with-profits benefits reserve

PRU 7.4.141R

In calculating the future policy related liabilities for a with-profits fund, a firm must make provision for any future planned enhancements to the with-profits benefits reserve for that fund that cannot be financed out of the resources of the with-profits benefits reserve and future premiums.

PRU 7.4.142G

For the purposes of PRU 7.4.141 R, planned enhancements to the with-profits benefits reserve will arise when a firm has a contractual obligation, or a non-contractual commitment (arising from its regulatory duty to treat customers fairly), to enhance claims on some classes of policy (perhaps in the form of specially enhanced future bonus rates). In such circumstances, the present value of the costs of paying out a target asset share that is more than the projected with-profits benefits reserve for those classes of policy for which this practice is applicable should be included in the amount of the future policy related liabilities. For example, a firm may have a non-contractual commitment (arising from its regulatory duty to treat customers fairly) to pay enhanced benefits but have discretion not to make such payments in adverse circumstances. Such planned enhancements should be provided for in the realistic balance sheet, but allowance should be made for management action in the calculation of the risk capital margin.

PRU 7.4.143G

The valuation of claims in excess of targeted asset shares in respect of guarantees, options and smoothing, including those arising under guaranteed annuity rates, should be carried out in accordance with PRU 7.4.169 R to PRU 7.4.186 G.

Planned deductions for the costs of guarantees, options and smoothing from the with-profits benefits reserve

PRU 7.4.144R

Where a firm expects to deduct future charges from the with-profits benefits reserve for a with-profits fund to cover the costs of guarantees, options or smoothing for that fund, the firm must take credit for these future charges in calculating the future policy related liabilities for that fund.

PRU 7.4.145G

In calculating future policy related liabilities for a with-profits fund, a firm should take credit under PRU 7.4.137 R (3) for the present value of the future "margins" available in respect of charges deducted to cover the costs of guarantees, options and smoothing. PRU 7.4.188 R requires firms that accumulate the charges made less costs incurred to provide for any surplus on the experience account as a realistic liability. Any such provision should be made under PRU 7.4.137 R (5), PRU 7.4.137 R (7) or PRU 7.4.137R (8) depending on the nature of the charges made, and has no effect on the amount calculated under PRU 7.4.144 R.

Planned deductions for other costs deemed chargeable to the with-profits benefits reserve

PRU 7.4.146R

Where a firm expects to deduct future charges (other than those valued in PRU 7.4.144 R) from the with-profits benefits reserve for a with-profits fund, the firm must take credit for these future charges in calculating the future policy-related liabilities for that fund.

PRU 7.4.147G

A firm should take credit for the present value of the other future "margins" available. The circumstances where such margins may arise include:

  1. (1)

    where a firm is targeting claims at less than 100% of the with-profits benefits reserve, the amount of such shortfall; and

  2. (2)

    where a firm expects to deduct any future charges (other than those for guarantees, options and smoothing) from the with-profits benefits reserve.

Future costs of contractual guarantees (other than financial options)

PRU 7.4.148R

A firm must make provision for the costs of paying excess claim amounts for a with-profits fund where the firm expects that the amount in (1) may be greater than the amount in (2), calculated as at the date of claim:

  1. (1)

    the value of guarantees arising under a policy or group of policies in the fund; and

  2. (2)

    the fund's with-profits benefits reserve allocated in respect of that policy or group of policies.

PRU 7.4.149R

For the purposes of PRU 7.4.148 R, the future costs of guarantees cannot be negative.

PRU 7.4.150G

In carrying out projections to calculate the cost of guarantees under PRU 7.4.137 R the opening liability should be set equal to the with-profits benefit reserve (see PRU 7.4.118 R), adjusted for miscellaneous surplus or deficits (see PRU 7.4.137 R (1)) and planned enhancements (see PRU 7.4.141 R).

PRU 7.4.151G

In projecting forward the with-profits benefits reserve, adjusted as in PRU 7.4.150 G, to the date of claim for the purposes of PRU 7.4.148 R, the firm should use market consistent assumptions for the expected future premium and investment income (including realised and unrealised gains or losses), expenses and claims, any charges to be deducted, tax and any other item of income or outgo. This projection should be carried out on the same basis as is described in PRU 7.4.130 R.

PRU 7.4.152G

PRU 7.4.169 R to PRU 7.4.186 G contain further rules and guidance on the valuation of guarantees, options and smoothing.

PRU 7.4.153G

Some examples of contractual guarantees are:

  1. (1)

    for conventional with-profits insurance contracts, guaranteed sums assured and bonuses on death, maturity or retirement; and

  2. (2)

    for accumulating with-profits policies, guarantees at a point in time or guaranteed minimum bonus rates.

Future costs of non-contractual commitments

PRU 7.4.154R

A firm must make provision for future costs in addition to those in PRU 7.4.148 R where the firm expects to pay further amounts to meet non-contractual commitments to customers or pay other benefits that need to be provided to fulfil a firm's regulatory duty to treat its customers fairly.

PRU 7.4.155G

Some examples of these non-contractual commitments are:

  1. (1)

    statements by the firm regarding the ability of policies to cover defined amounts, such as the repayment of a mortgage;

  2. (2)

    statements by the firm regarding regular withdrawals from a policy being without penalty;

  3. (3)

    guaranteed annuity and cash option rates being provided beyond the strict interpretation of the policy; and

  4. (4)

    the costs of any promises to customers or other benefits that need to be provided to fulfil a firm's regulatory duty to treat its customers fairly.

Future costs of financial options

PRU 7.4.156G

Financial options include guaranteed annuity and cash option rates.

PRU 7.4.157G

PRU 7.4.169 R to PRU 7.4.186 G contain further rules and guidance on the valuation of options.

Future costs of smoothing

PRU 7.4.158R

A firm must make provision for future smoothing costs of a with-profits fund where the firm expects that the claims paid on a policy or group of policies in the fund will vary from the greater of:

  1. (1)

    the value of guarantees determined in PRU 7.4.148 R in respect of that policy or group of policies; and

  2. (2)

    the fund's with-profits benefits reserve allocated in respect of that policy or group of policies which must be enhanced as described in PRU 7.4.141 R;

calculated as at the date of claim.

PRU 7.4.159R

For the purposes of PRU 7.4.158 R, smoothing costs are defined as the present value of the difference between projected claims and the projected with-profits benefit reserve after enhancements (PRU 7.4.141 R), other than payouts on guarantees (PRU 7.4.148 R).

PRU 7.4.160R

Subject to PRU 7.4.188 R, the future costs of smoothing can be negative.

PRU 7.4.161G

PRU 7.4.169 R to PRU 7.4.186 G contain further rules and guidance on the valuation of the future costs of smoothing.

Financing costs

PRU 7.4.162R

A firm must provide for future liabilities to repay financing costs of a with-profits fund where the firm expects to have to meet such liabilities and to the extent that these liabilities are not already provided for by amounts included in the fund's realistic current liabilities (PRU 7.4.190 R and PRU 7.4.191 R). The amount of the liabilities to repay financing costs must be assessed on a market-consistent basis.

PRU 7.4.163G

In PRU 7.4.162 R, financing costs refer to the future costs incurred by way of capital, interest and fees payable to the provider. A firm should make a realistic assessment of the requirement to repay such financing in its expected future circumstances (which may be worse than currently). Having taken account of its particular circumstances:

  1. (1)

    where a firm has no liability to repay such financing, it should not include such repayment as a liability;

  2. (2)

    where a firm has a reduced liability to repay such financing, it should include a reduced repayment as a liability.

PRU 7.4.164G

In PRU 7.4.162 R, financing includes reinsurance financing arrangements and analogous non-reinsurance financing arrangements, such as contingent loans, securitisations and any other arrangements giving rise to charges on future surplus arising.

Other long-term insurance liabilities

PRU 7.4.165R

A firm must provide for any other long-term insurance liabilities arising from or in connection with with-profits insurance contracts in a with-profits fund, to the extent that adequate provision has not been made in the with-profits benefits reserve or in any other part of the future policy related liabilities for that fund.

PRU 7.4.166G

Some examples of these other long-term insurance liabilities are:

  1. (1)

    pension and other mis-selling reserves;

  2. (2)

    provisions for tax; and

  3. (3)

    provisions for future shareholder transfers.

PRU 7.4.167G

In determining the realistic liability for taxation firms should apply the general principles set out in PRU 7.4.105 R and the guidance given in PRU 7.4.107 G.

PRU 7.4.168G

PRU 7.4.105 R requires firms to provide for shareholder transfers out of the with-profits fund as a liability of the fund. The provision should be consistent with the methods and assumptions used in valuing the other realistic liabilities. So, for example, where the with-profits benefits reserve includes amounts that would be paid to policyholders through future bonuses, provision should also be made for future shareholder transfers associated with those bonuses.

Valuing the costs of guarantees, options and smoothing

PRU 7.4.169R

For the purposes of PRU 7.4.137 R (5), PRU 7.4.137 R (7) and PRU 7.4.137 R (8), a firm must calculate the costs of any guarantees, options and smoothing using one or more of the following three methods:

  1. (1)

    a stochastic approach using a market-consistent asset model (PRU 7.4.170 R);

  2. (2)

    using the market costs of hedging the guarantee or option;

  3. (3)

    a series of deterministic projections with attributed probabilities.

PRU 7.4.170R

The market-consistent asset model in PRU 7.4.169 R (1):

  1. (1)

    means a model that delivers prices for assets and liabilities that can be directly verified from the market; and

  2. (2)

    must be calibrated to deliver market-consistent prices for those assets that reflect the nature and term of the with-profits insurance liabilities of the with-profits fund.

PRU 7.4.171G

Deterministic approaches will not usually capture the time value of the option generated by a guarantee. In order to calculate this value properly, firms are expected either to use market option values where these are readily available or to undertake a stochastic approach using a market-consistent asset model.

PRU 7.4.172G

The FSA considers stochastic modelling to be preferable for material groups or classes of with-profits insurance contracts unless it can be shown that more simplistic or alternative methods are both appropriate and sufficiently robust.

PRU 7.4.173G

Where the guarantee or option is relatively simple in nature, is capable of being hedged, and has a value unlikely to be affected by management actions (PRU 7.4.185 R) (for example, a guaranteed annuity rate option) then the cost of the guarantee or option would be the market cost of hedging the guarantee. Where that is generally the case but, in respect of a minor part of a portfolio, no market exists for hedging the option generated by the guarantee, a firm should take the value of the nearest equivalent benefit or right for which a market exists and record how it has adjusted the valuation to reflect the original option. Where the market value of the hedge is used firms should also make provisions for the credit risk arising from the hedge, both that arising from exposure to a counterparty and that arising from credit risk in the underlying instrument. The extent to which the guarantee or option is capable of being hedged depends on a firm's assumptions regarding future investment mix, persistency, annuitant mortality and take-up rates. While the FSA recognises that the hedge may not be perfectly matched to the underlying guarantee or option, a firm should ensure that hedge is reasonably well matched having regard to the sensitivity of the guarantee or option to the firm's choice of key assumptions.

PRU 7.4.174G

Where a firm has large cohorts of guarantees and uses stochastic or deterministic approaches, a firm should have regard to whether the cost of the guarantees determined under those approaches bears a reasonable relationship to the market cost of hedging those guarantees (where it exists).

PRU 7.4.175G

In determining the costs of smoothing, a firm should consider:

  1. (1)

    the consistency of its assumptions (including the exercise of management discretion over bonus rates); and

  2. (2)

    where targeted payouts currently exceed retrospective reserves in respect of those claims, the assumptions used in reducing the excess, if applicable,

having regard to the firm's PPFM and its regulatory duty to treat its customers fairly.

Stochastic approach

PRU 7.4.176G

For the purposes of PRU 7.4.169 R (1), a stochastic approach would consist of an appropriate market-consistent asset model for projections of asset prices and yields (such as equity prices, fixed interest yields and property yields), together with a dynamic model incorporating the corresponding value of liabilities and the impact of any foreseeable actions to be taken by management. Under the stochastic approach, the cost of the guarantee, option or smoothing would be equal to the average of these stochastic projections.

PRU 7.4.177G

In performing the projections of assets and liabilities under the stochastic approach in PRU 7.4.169 R (1), a firm should have regard to the aspects in (1) and (2).

  1. (1)

    The projection term should be long enough to capture all material cash flows arising from the contract or groups of contracts being valued. If the projection term does not extend to the term of the last policy, the firm should check that the shorter projection term does not significantly affect the results.

  2. (2)

    The number of projections should be sufficient to ensure a reasonable degree of convergence in the results, including the determination of the result of the risk capital margin. The firm should test the sensitivity of the results to the number of projections.

PRU 7.4.178G

The FSA considers a holistic approach to stochastic modelling to be preferable so as to value all items of costs together rather than using separate methods for different items of the realistic value of liabilities. This approach requires the projection of all material cash flows arising under the contract or group of contracts for each stochastic projection, rather than only those arising from the guarantee or option within the contract. The advantages of this approach are that it ensures greater consistency in the valuation of different components of the contract and explicitly takes into account the underlying hedges or risk mitigation between components of the contract or group of contracts being valued. Where a firm can use a stochastic approach to value simultaneously all components of the contract or group of contracts, the firm should adopt this approach where practical and feasible.

PRU 7.4.179G

Where a stochastic approach is used, a firm should make and retain a record under PRU 7.4.17 R of the nature of the asset model and of the assumptions used (including the volatility of asset values and any assumed correlations between asset classes or between asset classes and economic indicators, such as inflation).

PRU 7.4.180G

In calibrating asset models for the purposes of PRU 7.4.170 R, a firm should have regard to the aspects in (1), (2) and (3).

  1. (1)

    Few (if any) asset models can replicate all the observable market values for a wide range of asset classes. A firm should calibrate its asset models to reflect the nature and term of the fund's liabilities giving rise to significant guarantee and option costs.

  2. (2)

    A firm will need to apply judgement to determine suitable estimates of those parameters which cannot be implied from observable market prices (for example, long-term volatility). A firm should make and retain a record under PRU 7.4.17 R of the choice of parameters and the reasons for their use.

  3. (3)

    A firm should calibrate the model to the current risk-free yield curve. Risk-free yields should be determined after allowing for credit and all other risks arising. Firms may have regard to any guidance from the actuarial profession on the calculation of the risk-free yield but should not assume a higher yield than suggested by any such guidance.

Deterministic approach

PRU 7.4.181R

For the purposes of the deterministic approach in PRU 7.4.169 R (3), a firm must calculate a series of deterministic projections of the values of assets and corresponding liabilities, where each deterministic projection corresponds to a possible economic scenario or outcome.

PRU 7.4.182G

A firm should determine a range of scenarios or outcomes appropriate to both valuing the costs of the guarantee, option or smoothing and the underlying asset mix, together with the associated probability of occurrence. These probabilities of occurrence should be weighted towards adverse scenarios to reflect market pricing for risk. The costs of the guarantee, option or smoothing should be equal to the expected cost based on a series of deterministic projections of the values of assets and corresponding liabilities. In using a series of deterministic projections, a firm should consider whether its approach provides a suitably robust estimate of the costs of the guarantee, option or smoothing.

PRU 7.4.183G

In performing the projections of assets and liabilities under the deterministic approach in PRU 7.4.169 R (3), a firm should have regard to the aspects in (1) and (2).

  1. (1)

    The projection term should be long enough to capture all material cash flows arising from the contract or group of contracts being valued. If the projection term does not extend to the term of the last contract, the firm should check that the shorter projection term does not significantly affect the results.

  2. (2)

    The series of deterministic projections should be numerous enough to capture a wide range of possible outcomes and take into account the probability of each outcome's likelihood. The costs will be understated if only relatively benign or limited economic scenarios are considered.

PRU 7.4.184G

Where a series of deterministic projections is used, a firm should make and retain a record under PRU 7.4.17 R of the range of projections and how the probabilities attributed to each projection or outcome were determined (including the period of reference for any relevant data on past experience).

Management and policyholder actions

PRU 7.4.185R

In calculating the costs of any guarantees, options or smoothing, a firm:

  1. (1)

    may reflect its prospective management actions (within the meaning of PRU 7.4.53 R); and

  2. (2)

    must reflect a realistic assessment of the policyholder actions (within the meaning of PRU 7.4.59 R);

in its projections of the value of assets and liabilities.

PRU 7.4.186G

For the purposes of PRU 7.4.185 R, the related guidance in PRU 7.4.54 G to PRU 7.4.57 G (management actions) and in PRU 7.4.60 G (policyholder actions) applies.

Treatment of surplus on guarantees, options and smoothing

PRU 7.4.187R

PRU 7.4.188 R applies to firms calculating the costs of guarantees, options and smoothing to be included in the future policy-related liabilities in accordance with PRU 7.4.137 R (5), PRU 7.4.137 R (7) and PRU 7.4.137 R (8).

PRU 7.4.188R

Where a firm accumulates past experience and deducts or is otherwise able to take credit for charges for guarantees or options or smoothing, the future costs of guarantees or options or smoothing (as appropriate) must not be less than the greater of:

  1. (1)

    the prospective calculation of the future cost of guarantees (see PRU 7.4.148 R) or options (see PRU 7.4.156 G) or smoothing (see PRU 7.4.158 R) (as appropriate); and

  2. (2)

    the sum of:

    1. (a)

      the accumulated charges (after deduction of past costs) for guarantees or options or smoothing (as appropriate); and

    2. (b)

      the prospective calculation of the future charges deducted for guarantees or options or smoothing (see PRU 7.4.144 R) (as appropriate).

PRU 7.4.189G

The extent to which the amount in PRU 7.4.188 R (2) exceeds the amount in PRU 7.4.188 R (1) will determine the surplus available to support actions that would be taken by the firm's management. The purpose of PRU 7.4.188 R is to ensure that any resulting surplus at the valuation date arising from the accumulation of charges less costs remains available to support foreseeable actions that would be taken by the firm's management. Any additional liability arising from PRU 7.4.188 R is added to the liabilities under PRU 7.4.137 R (5), PRU 7.4.137 R (7) and PRU 7.4.137 R (8), but has no impact on the adjustment for planned deductions for the costs of guarantees, options and smoothing (PRU 7.4.137 R (3) and PRU 7.4.144 R).

Realistic current liabilities

PRU 7.4.190R

For the purposes of PRU 7.4.40 R (3), the realistic current liabilities of a with-profits fund are equal to the sum of the following amounts:

  1. (1)

    the firm's best estimate provision for those liabilities for which prudent provision is made in regulatory current liabilities (see PRU 7.4.30 R); and

  2. (2)

    to the extent that amounts have not been provided in (1), any tax and any other costs arising either in respect of excess admissible assets (within the meaning of PRU 7.4.36 R) or on the recognition of future shareholder transfers.

PRU 7.4.191R

For the purpose of1 assessing the best estimate provision to be made under PRU 7.4.190 R (1) in respect of a defined benefit occupational pension scheme1, a 1firm must use either its defined benefit liability or its deficit reduction amount, consistent with the firm's election under PRU 1.3.5BR (2)1.

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