ABI RESPONSE
TO
FINANCIAL SERVICES AUTHORITY
CONSULTATION PAPER 143
INTEGRATED PRUDENTIAL SOURCEBOOK: FEEDBACK ON
CHAPTERS OF CP97 APPLICABLE TO INSURANCE FIRMS
AND SUPPLEMENTARY CONSULTATION
October 2002
CONTENTS
OVERVIEW
1
Executive Summary
1.1
Consultation Issues Raised in CP143
1.2
Key ABI Response Points
DETAILED RESPONSE POINTS
2
Draft Rules and Guidelines on Credit Risk in Insurance Funds:
(PRU 3, Formerly PRCR) including Reinsurance Credit Risk
2.1
General Points
2.2
CP143 Questions and Responses on Credit and Reinsurance Credit
Risk
2.3
Credit and Reinsurance Credit Risk: Points on Individual
Rules/Guidance
3
Mathematical Reserves: (PRU7.3, formerly PRIR and with Profits
Insurance Capital Component (PRU7.4, formerly PRIR)
3.1
CP143 Questions and Responses on Mathematical Reserves and With
Profits Insurance Capital Component
3.2
Points on Individual Rules/Guidance on Mathematical Reserves
3.3
Points on Individual Rules/Guidance on With Profits Insurance Capital
Component
4
Handbook Definitions
5
Cost Benefit Analysis
2
ABI RESPONSE TO CP143: INTEGRATED PRUDENTIAL SOURCEBOOK:
FEEDBACK ON CHAPTERS OF CP97 APPLICABLE TO INSURANCE
FIRMS AND SUPPLEMENTARY CONSULTATION
1
EXECUTIVE SUMMARY
1.1
Consultation Issues Raised in CP143
1.1.1 These cover three separate areas:

Credit Risk in Insurance Funds including Reinsurance Credit Risk
which applies to both life and non-life insurance;

Mathematical Reserves for Life Assurers, and

The With-profits Insurance Capital Component for Life Assurers.
1.1.2 CP143 raises the following key issues:


The Credit Risk proposals cover:

Credit risk generally building on an approach of
inadmissibility in cases of excessive concentration as laid
down in the Directives together with an overarching
diversification and prudence approach;

Reinsurance Credit Risk where the approach is to require
notification to the FSA where exposure to a single reinsurer
or reinsurance group exceeds the amount of the insurer’s
capital or where premiums ceded to a single reinsurer
exceed the higher of 20% of premiums or £4 million a year.
The Mathematical Reserve proposals cover:


Rules and guidance on the calculation of mathematical
reserves including requirements relating to the valuation of
policyholder options.
The With-Profits Capital Component proposals cover:

A “Twin Test” approach of providing for an additional capital
or solvency requirement equal to the amount by which a
realistic assessment of liabilities to policyholders including
terminal bonuses exceeds the current prudent statutory basis
3
reserves which are not required to provide for terminal or
final bonuses.
1.2
Key ABI Response Points
1.2.1 CP143 consults on three important areas.
We welcome this
consultation and raise a number of points on the policy and detail. In
particular, the opportunity should be taken in every case to move as far
as permitted by EU Directives to a realistic valuation basis. The WithProfits Insurance Capital Component is a welcome recognition of this
approach.
1.2.2 Credit Risk

The approach of requiring notification where
exposures exceed prescribed limits is correct:
reinsurance

Guidance on acceptable arrangements should be given
particularly where high levels of reinsurance concentration are
appropriate, eg some group reinsurance arrangements;

The guidance proposed is broader than reinsurance credit risk
and this should be highlighted and signposted by references to
other sections of the PSB;

The tone of the draft guidance is too negative. This should be
remedied by mention of the important role of reinsurance in
limiting insurance risk.
1.2.3 Mathematical Reserves

The rules should move as far as permitted by the Directives to a
realistic valuation basis. In particular assumptions as to take-up
of options, lapse rates and expenses should be based on the
most likely outcome subject to an appropriate margin for adverse
deviation.

Alignment is needed of proposals for the treatment of reinsurance
and emerging surplus in this CP and with those in CP144 on
Financial Engineering: in particular there should be no restriction
on appropriate reinsurance of policyholder funds and the rules
should not be more restrictive than for implicit items.

A considerable number of points of detail have been identified and
need to be addressed in this section and that relating to the WithProfits Insurance Capital Component. We suggest that an early
redraft should be made available for consultation. If this is not
possible, we would be prepared to have detailed discussions on
these with the FSA.
4
1.2.4 The With-Profits Insurance Capital Component

A “Twin Test” calculation giving rise to a capital requirement is the
correct approach as a liability requirement would increase
solvency requirements and potentially limit investment flexibility;

All inadmissible assets backing with-profits business should be
taken into account in calculating the WPICC and not only those
inadmissible because of the size of the holding as proposed.

More guidance should be given on the calculation of the “realistic”
assessment of liabilities including final or terminal bonuses; and

Further details are awaited of the reporting proposals, already
discussed in With-Profits Issue Paper No 2.
1.2.5 General

The production of figures under the new bases for all three heads
will be a considerable undertaking and a challenge at year-end
2004 particularly for companies with a year-end prior to the
calendar year-end. We urge that comparatives should not be
required on the new bases for a further year thereafter and that
proper transitional arrangements should apply.

We plan to raise the tax implications of the changes to the
resilience reserves with the Inland Revenue and are concerned
that there should be no detriment to policyholders.
2
DETAILED RESPONSE POINTS
2.1
Draft Rules and Guidance on Credit Risk in Insurance Funds:
(PRU 3, formerly PRCR) including Reinsurance Credit Risk
General Points
2.1.1 A number of points arise as to the approach adopted for this module of
the Integrated Prudential Sourcebook as regards insurers’ credit risk in
general and reinsurance credit risk in particular:

A considerable proportion of the rules and guidance text material
relates primarily to risks other than credit risk which is the risk of
default by the reinsurer. For example, adequacy of reinsurance
cover is relevant to capital adequacy and insurance risk systems
and controls. In some cases, disputes between reinsurers and
direct writers relate to contractual and documentary risk. These
and similar, non-credit risk aspects should be the subject of
suitable “ signposting”;
5

The rules operate by requiring notification in certain
circumstances to the FSA. The guidance should be extended to
explain FSA policy in dealing with such notifications particularly
for situations likely to occur reasonably frequently such as intragroup reinsurance and large catastrophe recoveries. While credit
risk issues are important in these circumstances, they would
usually be manageable and in such cases it should be clear that
levels above the notification limits are acceptable.
2.1.2 The notification limits are particularly likely to be reached with intragroup transactions. For instance:

All business in a life group is written in the main company for
marketing reasons. Some is immediately reinsured to specialist
subsidiary or associated companies, typically linked business,
annuity and pension business and perhaps PHI. This can easily
lead to breach of these limits even though from a regulatory
perspective there is no increased risk, in fact sometimes quite the
contrary. While the detail will vary the business rationale is likely
to be based on:

Management of different streams of business in self
standing subsidiaries to strengthen management
accountability;

Increased reporting transparency: in particular the
solvency/free asset expectations are different for the
various categories and having different operating
subsidiaries enhances transparency which also helps
consumer information;

Taxation benefits, particularly avoiding the volatility of a
fund combining different categories: in many cases the
main incentive is to avoid the unpredictability and volatility
of tax result which can arise from combining the
businesses in one company.

A group uses one company, on either the life or non-life side, to
take advantage of the right of establishment under the EU
passporting provisions and reinsures the business to the other
group companies which specialise in the different lines.

A group has a number of subsidiaries with brand strengths in
different areas but for business reasons reinsures into another
group company. This can happen on the life or non-life side.
2.1.3 In addition the limits are likely to be breached with reinsurance
arrangements with third party reinsurers.
6

Increasingly a single shop or “open architecture” approach is
being used under which a life insurer will offer investment
products from other providers within the envelope of a single
linked policy. In such cases, reinsurance may be used as the
means of providing the link and may breach the notification limits.

Reinsurance may be used by life insurers managing linked life
funds who are prohibited by Section 23 of the Companies Act
from holding shares in their quoted parent company to obtain
exposure to the parent company, e.g. as a constituent of an
index. Where the RMM requirements are low, typically because
investment risk is borne by the policyholder, the notification limits
are likely to be breached.
2.1.4 The rules/guidance require notification to the FSA and the FSA clearly
needs such information to assess insurers’ operations. An indication of
FSA policy in dealing with such notifications should be given in the
guidance. Where the structures assist regulatory objectives by giving
greater clarity, they are presumably to be encouraged. This is not clear
from the present text. In other cases the effect may be neutral. The
regulatory aim must be to identify transparently practices which are
harmful. Guidance on FSA policy towards notifications would serve the
following objectives:

Assisting insurers in the management of risk and reinsurance
programmes,

Assisting line regulators particularly those new to the area;

Assisting advisors and journalists in understanding insurers’
figures: the present text is likely to cast doubt in their minds in
cases where this is not justified.
2.2
CP143 Questions and Responses on Credit and Reinsurance
Credit Risk
Q1
Do you agree that a reinsurance premium concentration limit and a
reinsurance exposure limit are the most appropriate and effective
means of limiting the credit risk that can arise from excessive
reinsurance concentration?
2.2.1 A reinsurance premium concentration limit and a reinsurance exposure
limit are an appropriate starting point to consider credit risk in respect
of reinsurance transactions. They should not be regarded as inflexible
prescriptive rules.
2.2.2 Firstly, credit risk has also to seen in the context of insurance and
operational risk.
With catastrophe covers, which should be
encouraged where appropriate, it is foreseeable that the concentration
limit may be breached in the event of a very severe claim which is
7
precisely what such cover is designed for. It is essential for the rules
on reinsurance credit not to act as a disincentive to seeking appropriate
cover and we are concerned that the current tone of the guidance
could have this effect. This is particularly to the point where only a
limited number of reinsurers provide cover in a particular area.
2.2.3 Catastrophe cover is needed because of the relative size of the risk, or
collection of risks, to the individual insurer’s financial resources. This
means, as is acknowledged in the Consultation Paper, that the
likelihood of exceeding the suggested limits are much greater for
smaller companies than for large ones.
2.2.4 Secondly, for the reasons outlined above, the suggested limits may not
be appropriate in the case of intra-group reinsurance. As argued
above, there can be compelling regulatory attractions for such
arrangements. Credit concerns need to be met through appropriate
systems and controls in such cases rather than numerical limits.
2.2.5 It should also be noted that the majority of non-life claims against
reinsurers are likely to be of a contingent nature, ie to relate to reserves
to pay claims incurred, whether reported on not, where a settlement
has not yet been reached with the policyholder. Similarly with life
business the reinsurance cover may relate to, for instance, mortality
claims which will occur over an extended period. With both life and
non-life business there are likely to be different levels of cover provided
by different reinsurers. The insurer must be satisfied that the cover is
adequate in foreseeable circumstances. The interaction between
different reinsurance treaties can mean analysis between different
reinsurers may be less simple than suggested in the guidance: for
instance the interaction between excess of loss cover on an individual
claims basis and excess of loss cover across the account. Provision
should be made in the guidance for appropriate recourse to estimation
techniques rather than the present flavour of exact quantification.
2.2.6 The longer term objective must be to cover reinsurance, and other
credit, risk as part of the assessment of economic capital requirements.
This will depend upon realistic accounting and a more scientific method
of risk assessment. In the short term the guidance should encourage
insurers who wish to use such approaches to do so and provide for
recognition where this is done.
2.2.7 The guidance does not define when the reinsurer fails to meet its
obligations. The point at which failure is recognised is relevant
because the exposure to an individual reinsurer varies, sometimes
materially, over the life of a treaty. Current exposure does not
necessarily adequately capture the risks to which the fund is exposed.
Should guidance be provided on future exposure resulting from present
contractual obligations and what should the net asset comparator be?
8
Q2
Do you agree that the limits are set at a suitable level?
2.2.8 The limits are probably set at a not unreasonable level for notification
to the FSA under 3.10.29R and 3.10.35R. The major question, which
should be clarified in guidance, relates to the FSA approach in
response. We would urge that this should in particular cover:

Large excess of loss and similar catastrophe recoveries;

Common intra-group transactions as discussed above.
2.2.9 The guidance should indicate:

Circumstances where no further action is to be expected;

Clarify that reaching the limits gives rise to a notification duty only
and that amounts in excess are not automatically inadmissible or
in breach of an insurer’s duties under the rules;

Stress that reinsurance cover is an appropriate insurance risk
management tool and that credit risk considerations are only one,
albeit an important, aspect to be considered by the insurer.
2.2.10 As the consultation paper acknowledges, problems are most likely to
arise with small insurers and hence the £4 million alternative limit in
3.10.31E. For that reason guidance is particularly important as many
such firms will be low impact and will not have the same opportunity to
discuss matters with their regulator as those in larger firms.
Q3
Would it be useful if we included further guidance, for instance in the
form of flow charts, on how to apply the counterparty limits?
Such guidance could be very useful. It should apply to all credit risk
and not be limited to reinsurance credit risk.
2.3
Credit and Reinsurance Credit Risk: Points on individual rules/
guidance
3.10.3G
2.3.1 This summarises the guidance as covering credit matters. If other
matters, particularly those relating to wider aspects of reinsurance, are
to be covered in the module, attention should be drawn to them here.
3.10.4G
2.3.2 A cross reference to PRIR and reinsurance in underwriting( PRIR
1.3.2(4)), claims management (PRIR 1.3.3(2)), records (PRIR 1.3.8(6))
and capital adequacy (PRIR 2.3.6) and similar references would
appear appropriate.
9
3.10.5G
2.3.3 The importance of contingent (increased) exposure is analysed in
terms of credit risk. Surely this analysis is more important for insurers
in terms of underwriting/reserving risk where the whole point is to
ensure adequate cover in changed circumstances? Measurement
would appear primarily part of stress/scenario testing for adequacy of
capital resources, on which consultation is awaited, with credit risk
being a second order but very important consideration.
3.10.6G
2.3.4 This guidance is concerned with the implications of credit risk for credit
derivatives and credit insurance. This should be cross referred to in
the rules/guidance on insurance risk, eg underwriting etc in PRIR, as
applicable to credit insurers which may need to be expanded.
3.10.7G
2.3.5 Again a lot of this guidance should be cross referred to in the relevant
sections of PRIR.
3.10.7(5)G
2.3.6 Should the guidance on derivatives refer to the possibility of an asset
becoming a liability/ a form of reverse credit risk?
3.10.8G
2.3.7 The reference to “rules” should also cover guidance and evidential
provisions.
3.10.9G
2.3.8 This should also cross refer to 3.10.7G.
3.10.10G
2.3.9 This cross-refers to the rule in PRMR12.3.1 including the requirement
that derivatives should be held for efficient portfolio management or
reduction of investment mismatch. The guidance that a significant
exposure to credit risk does not achieve these purposes even if it
results in the reduction in other risks, eg market risk, needs
clarification. Presumably “credit risk“ here means a significant risk of
default and not a significant exposure relative to the risk being covered
by the derivative as otherwise the effect would be greatly to reduce the
scope for use of derivatives as an overall risk reduction mechanism.
10
3.10.11R
2.3.10 A number of points arise:

It would be helpful if this rule could have an explanatory note to
point out that it covers “ credit risk” because much of the wording
suggests that it covers “market risk” where similar principles apply
which are the subject of PRMR11 for insurers;

In particular it would be helpful to mention the areas where it is
most likely to be applicable, eg brokers balances, reinsurance
recoveries, subrogation recoveries, bank and similar deposits and
balances with stock brokers and recoveries under derivative
contracts

The approach in the rule of diversification and prudence underlies
the regulatory approach from core principles downwards. What is
“so that it will remain able to meet its liabilities as they fall due”
meant to add in the context of “credit risk”? This suggests some
form of overall financial resources stress test which would not be
limited to credit risk and here does not seem the place for it.
3.10.12/13/14/15G
2.3.11 These sets of guidance can be looked at either:

In terms of high-level principles, or

In terms of compliance objectives where the major question
becomes one of degree of depth with which each is approached
and record keeping.
2.3.12 The approach intended, as we understand it, is to place the onus on
management to use a risk based approach including an assessment of
materiality. The impression given by the rules is that regulators will be
looking for documentation to cover each of the issues raised in each
case. It would be better if the guidance could be less prescriptive and
bring out that different insurers will have different profiles which will
need to be covered differently.
3.10.18R
2.3.13 This rule requires “appropriate professional advice” if a firm is to rely on
“preferential access” to a counterparty’s assets. It would be helpful for
this to clarify that appropriate professional advice does not necessarily
imply external professional advice.
11
3.10.12R
2.3.14 Does a “counterparty “ include a custodian for the purposes of this rule
which effectively requires a stress test to determine whether the failure
of a counterparty would cause the insurer to default? The answer
appears to depend on whether the default of the custodian would affect
the assets held but amplification on the point appears welcome.
3.10.25R and 3.10.26R
2.3.15 These two rules apply the Directive approach to asset admissibility.
The text would be clearer if it made plain the effect of the rules that
excess holdings are inadmissible as opposed to constituting a breach
of the rules.
3.10.26 expresses the limits in terms of percentages of technical
reserves. This approach follows the directive but is inconsistent with
the current UK approach of applying the directives to all assets and
reduces the comparative proportion of the assets which may be
admissible.
3.10.27R and 3.10.28R
2.3.16 What is an investment fund for the purposes of rule 3.10.27. Are unit
trusts and OIECs treated differently?
3.10.29R
2.3.17 Major points on this rule are made in the introduction to this section
above.
Other points:

The test is by reference to an insurers’ capital. This should be
formally defined. Informally we understand that the FSA intention
is to define it as the excess of admissible assets over liabilities as
shown in the FSA Return;

Greater certainty is required on the calculation of the “exposure”
to a reinsurer (see comments on Rule 3.10.37 below);

How is the test to be applied in a composite insurer? Presumably
the life and non-life elements will be treated separately?
3.10.30G
2.3.18 Is the test of a “reasonably prudent provision for credit loss which is
reasonably foreseeable” the same as that applied by generally
accepted accounting standards such as the ABI SORP? If so, this
should be stated, otherwise the difference should be made clear:
12
3.10.31E
2.3.19 The comments made in the introduction to this section apply to this
evidential provision; Also:

A test by reference to gross earned premiums for the year may be
inappropriate when a block of business is reinsured. This may
relate to blocks of business written in previous years particularly
with life and long-tail non-life business;

This guidance is not suited for run-off business where no
premiums are being written.
3.10.35R
2.3.20 This rule should have guidance to cover situations where noncompliance with 3.10.3E is to be expected: see introduction to section.
3.10.36G
2.3.21 It might be helpful to note that in some circumstances all that will be
required is a simple explanation that the exposure will be selfcorrecting, eg when a large recoverable arises to meet catastrophe
claims.
3.10.37R
2.3.22 It is not clear whether the calculation of “reinsurance exposure” by
reference to net assets is the same test as used in the ABI SORP in
calculating the relevant liabilities and reinsurance recoveries or
whether a different test is expected in which case it should be
specified. It is important to avoid parallel similar calculations unless
there is good reason. Our preferred approach is to use the SORP
approach which fits in with the alignment of valuation rules to UK
accounting standards as discussed in paragraph 2.11 of the CP.
3
MATHEMATICAL RESERVES: (PRU 7.3, FORMERLY PRIR) AND
WITH-PROFITS INSURANCE CAPITAL COMPONENT (PRU 7.4,
FORMERLY PRIR)
3.1
CP143 Questions and Responses on Mathematical Reserves and With
Profits Insurance Capital Component
Q4
Do you agree with the new proposed “Twin Test” approach for the
treatment of final bonuses?
3.1.1 Yes. This approach combines the objectives of consumer protection
and regulatory transparency while avoiding increases to liabilities which
would have the effect of further restricting investment flexibility. In
13
particular it avoids the problems which would have arisen with “margins
on margins” and the resilience reserve if provision for final bonuses
had been included as a liability.
3.1.2 The twin test approach is based on a comparison of the attributable
solvency margin and mathematical reserves calculated on the statutory
basis with a calculation including provision for future final bonuses
calculated on a realistic or fair value basis. Relatively little detail is
given of the realistic methodology applicable for such a basis in
practice which is important to ensure consistency between insurers.
More detailed guidance would be valuable. With-Profits Review Paper
No 2 discussed many of the issues involved in the calculation of the
with-profits benefits reserve with more detail than is included in the
draft rules and guidance. We await further consultation on these.
3.1.3 It is important for the headings, descriptions and layouts used in the
relevant reporting forms to be properly thought through so that they are
as helpful to users as possible and do not mislead users with nonspecialist knowledge of the industry. It is also important for the
calculation to be properly understood. In particular we are concerned
that the difference between the two amounts in the Twin Test may not
be properly understood. For instance:

The absence of a capital component could be interpreted as an
absence of funding for future final bonuses while it may in fact be
an indication of the strength of the fund;

Conversely, a high capital component does not necessarily mean
a higher ability to pay final bonuses: in each case a judgment
depends on a range of factors including strength of reserving in
the first test and the bonus policy adopted including the
proportionate weighting given to ongoing reversionary bonuses
and final bonuses;

Similarly the “Free Asset Ratio” depends on a number of factors
and caution must be given to its interpretation.
3.1.4 It is arguable that the guidance should provide more detail on the
FSA’s views on the concept of a realistic valuation. While accounting
is moving in this direction and some high level principles are emerging
a lot of the detail has still to be developed. Alternatively an approach of
leaving the management of each company responsible for the realistic
calculation could be adopted but in this case it should be clearly stated.
Such an approach would fit with the move to a concept of responsibility
by firms for their risks rather than a single prescriptive approach.
3.1.5 A particular point arises on the realistic calculation which should be
raised at this stage. The present drafting provides for assets in excess
of the admissibility limits to be taken into account in the realistic
valuation. In accordance with the realistic approach account should be
14
taken of all inadmissible assets which in the view of the insurer are
available to meet with profits expectations. In particular derivatives can
have an important role here where they are held, for instance, to hedge
interest risks on guarantee annuity options.
3.1.6 A number of points arise on the drafting of the text of the proposals and
these are dealt with below.
Q5
For overseas firms, should the rules in PRIR 3 apply worldwide or just
to the UK branch business?
3.1.7 The approach should be based on extent to which home country
activities could affect UK policyholders. Other relevant factors include:
3.2

Extent or otherwise of UK style with-profits written outside UK (if
not written outside UK, then extension would not affect them);

Regulatory position concerning with-profits in home jurisdiction
and need to avoid regulatory duplication;

Position of products in other jurisdictions similar in concept to
with-profits and how they would be treated.
Points on Individual Rules/Guidance (PRU 7.3 Mathematical
Reserves)
7.3.10
3.2.1 Ahead of the development of internationally agreed actuarial
standards, an approach of “paying regard to best actuarial practice”
may be more appropriate than a requirement to follow “generally
accepted actuarial best practice” particularly in areas where practice is
developing and may not be standardised such as the calculations for
the With-Profits Capital Requirement.
7.3.12
3.2.2 The requirement to state the effects of changes should be qualified,
like the approach to quantification of changes, by insertion of “as far as
practicable” before changes.
7.3.15
3.2.3 This rule on margins for adverse deviation should clarify that it does not
require account to be taken in the calculation of the margins for
adverse deviation of market risk which is currently the subject of the
resilience reserve and will be, subject to consultation, covered by a
new capital requirement.
15
7.3.16
3.2.4 The guidance about considering the risk premium that an independent
reinsurer would require should be limited to cases where there is a
sufficiently developed and diversified market for the particular form of
risk. In particular:

Only a single reinsurer may write the particular form of risk;

The premium charged is often dependent on the size of the risk
and the spread of risks in a particular block of business, eg
mortality risk of a whole block of business or of selected risks in
that block may be very different, and

It should not be assumed that reinsurers will be willing to make
available premium rates in cases where no business is likely to
result to them particularly where production of a quotation by the
reinsurer requires actuarial and other calculations by the
reinsurer.
7.3.17
3.2.5 This guidance concerns use of external proxies for market risk
premiums when these are not available. A number of points arise:

The words “proxy for the market risk” would be better described
as “proxy for the risk”. “Market risk” has a technical meaning
which could suggest a reference only to investment markets when
in fact the risk premium will depend on financial, mortality and
similar factors;

Stochastic models are valuable when there is a broad range of
possible outcomes but in other cases when the range of
outcomes is narrower other approaches such as adjusted
mortality tables are more appropriate. The guidance should make
this clear.

A prime purpose of an adverse deviation margins is to cover
cases where it is not possible to calibrate stochastic models:
again this point should be made.
7.3.24 and 7.3.25
3.2.6 Rule 7.3.24 is drafted in terms of individual contracts and the guidance
in 7.3.25 expands the rule to cover groups of contracts. It would
appear more appropriate for the two to be combined into a single rule.
16
7.3.26
3.2.7 The guidance here should follow GN8 3.3.5 where in stead of “at any
time” the guidance is to carry out specimen calculations when
calculation at every future duration is inappropriately onerous.
7.3.27
3.2.8 It would be helpful to include a reference to future premiums subject to
7.3.33 in the list of cashflows to be valued.
7.3.27 and 7.3.32
3.2.9 The interaction of this rule with 7.3.27 is unclear. 7.3.33 is drafted on
the basis of a net premium approach by requiring the value attributed
to the future premium not to exceed that attributable to a net premium.
As the net premium is calculated after an implicit allowance for
expenses, there is an inconsistency with the requirement to include a
provision for future expenses under 7.3.27. 7.3.27 should be clarified
to permit an implicit or net premium approach to expenses and it
should be noted that the criteria in 7.3.47 relating to prudent provision
for expenses applies both to explicit and implicit methods.
7.3.38
3.2.10 This rule seems to repeat 7.3.10 and it is not certain what it is expected
to add.
7.3.40
3.2.11 Two points:

The net premium is a valuation concept and it therefore appears
more appropriate not to preface it with the words “the value of“ in
the first line;

The cross referencing in the first indent of 7.3.40(1)(a) should also
include (4);
7.3.49
3.2.12 The reference to “ surplus “ in 7.3.49(1) should be to “margins”.
7.3.53
3.2.13 The requirement to set mortality and morbidity by reference to the
residence of the policyholder should be by reference to the residence
of the life or lives assured. This can be seen clearly in the case of a
group policy where the policyholder is the employer and the employees
17
are based in different countries with different mortality and morbidity
expectations.
7.3.59 and 7.3.62
3.2.14 The implications of the first sentence about providing for the benefit
which the firm expects the policyholder to be most likely to take are not
clear particularly when read in conjunction with 7.3.62 which is in terms
of the benefit of the greatest benefit (to whom unspecified) which
presumably is meant to cover the greatest cost to the firm. It is not
clear how this would operate if the firm expected 60% to choose the
option that was cheaper to the firm and 40% the option most expensive
to the firm. We favour an approach of providing for the most likely
outcome subject to an appropriate margin for adverse deviation.
7.3.60
3.2.15 The guidance here should restrict the recommendation to use
stochastic models to cases where calibration is possible and where
there is a sufficiently wide range of outcomes for this to be the
appropriate approach. This point is also raised under 7.3.17 above.
Stochastic modelling is valuable in cases where there is a wide range
of outcomes such as in financial markets. Some options in policies are
linked to these, eg guaranteed annuity rate options. Others such as
options to increase cover irrespective of state of health are primarily
linked to factors such as morbidity for which stochastic methods are
inappropriate.
3.2.16 The use, or otherwise, of stochastic models also depends upon the
approach to be followed in respect of 7.3.59 and 7.3.62. If a worst
case scenario is to be used, there is no need for a stochastic approach.
7.3.63
3.2.17 The position would be set out more accurately if “the option has value
whether it is exercised or not” were amended to read “the option has
value whether it is expected to be exercised or not”;
7.3.67

The requirement to provide on the basis of the worst case
scenario should be in terms of the worst case scenario
reasonably foreseeable;

The guidance should provide only for the calculations to be done
on a reasonable basis: for instance with expense guarantees to
ascertain the worst case possible would require examination of
the impact at every future point in time when a policy could be
discontinued which would be very complex especially when the
18
right to discontinue is continuous and not a predetermined
intervals. The value of such a calculation is also subject to doubt.
7.3.75G
3.2.18 This rule bars recognition of future surplus under reinsurance contracts
except in the case of shareholder funds. This approach conflicts with
the approach in CP144 for financial engineering which applies an
approach consistent with that for implicit items. We would argue that
future surplus should be capable of recognition for the purposes of
rules 7.3.71 and 7.3.74 to the extent that it does not accrue to the
benefit of with-profits policyholders e.g. non-profit and linked business
or is not required to meet statutory obligations. There is a case for a
degree of greater flexibility particularly in the case of mutuals because
all surplus accrues to the with-profits policyholders and also where the
transactions do not affect asset shares. In all cases due regard should
be had to the effect of the transactions on the overall risk reduction and
management of the with-profit fund. Provided the guidance is to be
interpreted in this spirit, departure from it should be acceptable.
3.3
Points on Individual Rules/Guidance (PRU 7.4 With-Profits
Insurance Capital Component)
7.4.7G
3.3.1 The proposed flowchart is not included in the CP. It would be useful to
have it for consideration.
7.4.8R
3.3.2 This rule provides the calculation of the with-profits capital requirement
by reference to items attributable to with-profits business. It should
clarify how excess admissible assets are attributable to with-profits
business: is this at the discretion of the company or is some form of
pro-rata approach envisaged?
3.3.3 We urge that all inadmissible assets backing with-profits business
should be allowed to be taken into account to reflect their economic
role when calculating the WPICC. Under the current draft account can
be taken only of assets inadmissible by reason of the size of the
holding. This should be extended to cover all inadmissible assets
recognised under a realistic accounting basis, notably derivatives,
acquisition costs of properties and interests in subsidiary companies.
3.3.4 Paragraph 14.6 suggests that assets in excess of admissibility limits
are a deduction from the with-profits benefits reserve rather than an
increase in the assets available to meet the sum of the solvency
requirement and relevant mathematical liabilities. Does anything turn
on this difference in treatment?
19
3.3.5 “Assets in excess of admissibility limits” as used in paragraph 14.6
appears clearer than “excess admissible assets” as used in the draft
text which can be mistaken to mean admissible assets in excess of the
solvency margin and mathematical reserves. It does not, however,
cover the point, which is clear from the definition section, that it is
meant to apply to assets which are inadmissible only by reason of
being in excess of the holding limits. A clearer expression might be
“assets inadmissible by reason of exceeding the admissibility limits”.
7.4.11R
3.3.6 Would it be helpful to include guidance to the effect that all liabilities to
policyholders are covered including guarantees and the value of
options? What is the rationale for excluding liabilities from deposit
back arrangements?
7.4.13
Two points;

The requirement in 7.4.13 (4) to take into account “discretionary
benefits and charges which must be at least equal to the amount
required by the firm to fulfil its regulatory duties to pay due
regard…” would be better phrased “discretionary benefits at least
equal to, and charges no more than, the levels required…”.

The comments relating to actuarial practice in 7.3.10 above also
apply to 7.4.13(5)
7.4.16-7.4.19
3.3.7 Is a separate valuation for each contract basis appropriate in
calculating the With-Profits Insurance Component? Clearly, it has to
be the starting point but the WPCC is meant to be calculated on a
realistic basis and in accordance with such a basis 7.4.18 permits a
contract to be treated as an asset unlike the prudent basis. This
suggests that the wording of this section places too much emphasis on
a separate valuation for each contract. It would appear better for:

the section to be headed “ Valuation of contracts”,

for it to say that a separate valuation approach is only the starting
point,

for the permitting of contracts as assets to be in the body of the
rule, and

for the guidance to clarify that in most cases an overall (pooled or
aggregate) approach is likely to be appropriate under any of the
three methods. In particular the wording should clarify that an
approach to the calculation of aggregate shares and future cash
20
flows on a specimen policy (or specimen with-profits unit) basis is
permitted to reflect the practice in many offices.
7.4.17
3.3.8 The guidance here appears applicable to the prospective cash-flow
method and should be under that head, ie 7.4.20 et seq.
7.4.21
3.3.9 This refers to cash flows “….in principle the same as those valued
under mathematical reserves”. Does this mean it will not be possible to
assume any additional lapses under the prospective method?
7.4.21 and 7.4.25
3.3.10 Both of these should have a consistent approach requiring records to
be kept. The methodology and assumptions, including assessments of
market movements, business strategy and expense levels which may
include future redundancies, are commercially and probably price
sensitive and should not be revealed in the public domain.
7.4.22 and 7.4.27
3.3.11 The references to final bonuses declared should be to final bonuses
added. A declaration is made of final bonuses at, say, the beginning of
the year and these are subsequently added as maturity etc occurs
which is the point in time affecting the cash-flows which the realistic
basis is seeking to capture.
7.4.23
3.3.12 A number of points:

It is important to note that that there are various methodologies for
calculating asset shares and the rules and guidance should
recognise this;

Asset share calculations do involve cash flows but are wider and
also take account of movements in asset and liability valuations
and the terminology should reflect this;

The list of cash flows and movements in value should be
extended to include:
o
Asset appreciation/depreciation;
o
Movements in provisions for liabilities including those relating
to expenses
21

o
Movements for reserves for mortality, funding for guarantees
on future payouts, funding for future smoothing etc
o
Provisions for charges (as opposed to expenses), mortality
etc where the risk for these is met by the insurer in return for
a charge on the fund;
Reinsurance should be included only in cases where it affects the
asset shares and should then be accounted for on a accruals
basis and not a cash basis as suggested by the current wording.
7.4.27
3.3.13 This rule as currently drafted deals with “benefits in excess of asset
shares”. A number of fundamental points arise:

Asset share is a methodology to give a guideline as to benefit
expectations and is not usually a precise indication of payout
levels from individual policies because, to take just one instance,
of the smoothing effect of with-profits bonus declarations;

While it is founded on a retrospective calculation of current asset
share, in practice the most important aspect is its use on a
projected basis to determine funds needed now to provide for a
level of bonus declarations to satisfy PRE;

Smoothing and guarantees approach which mean in practice that
some policyholders receive more than their asset share and
others less.

New, more transparent forms of with-profits can involve
guarantees being funded by explicit deductions from asset shares
over the lifetime of the policy including the future as well as the
past. The same effect is achieved for some more traditional forms
of with-profits by paying out less than the asset share when the
guarantee is not biting.

There can also be increases to asset shares through the addition
of, for instance, surplus from non-profit business.

The effect of the present drafting is to require an additional
provision to be made on each occasion where an insurer plans to
declare bonuses above asset share but with no corresponding
adjustment for bonus payments below the current asset share
level. One effect of this would to discourage the smoothing which
is a major attraction of with profits business to consumers.
Another would be to require the holding of more capital than is
required on a realistic basis.
22
3.3.14 The implications for the rule and guidance are:

The reference to “benefits in excess of asset share” should be
redrafted to allow for benefits being less than asset shares to the
extent that this is consistent with PRE;

The rule should be limited to the extent to which over a long
period of time the insurer expects the differences between
payouts and asset share to require additional funding for the withprofits business;

The guidance should place more emphasis on the considerations
affecting projections of asset shares which are likely to include
stochastic modelling of financial markets. It should also refer to
the future adjustments to asset shares that would result from the
assumptions, particularly for financial markets, assumed in the
projections and any stochastic modelling.
3.3.15 A number of other points arise:

The aim is a realistic calculation and the guidance should specify
that this approach is to be followed with for instance realistic
assessments of future events such as surrenders etc;

The projected transfers to shareholders should be covered in the
calculation;

Provision should be made in the calculation for the effect of
guarantees and options and the approach to be followed: a cross
reference to 7.3.57 to 7.3.63 would be appropriate.
7.4.29-34
3.3.16 This rule specifies that under the profit accrual method the With Profits
Insurance Capital Component equals the sum of the technical
provisions relating to with profits business and the fund for future
appropriations. The following points arise:

The fund for future appropriations includes funds providing
security for non with profits business and to attribute it all to with
profits business overstates the assets properly available to back
with-profits business;

Where the fund for future appreciation covers some or all of the
required solvency margin, how is this to be treated?
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4
HANDBOOK DEFINITIONS
4.1
Excess Admissible Assets
4.1.1 A broader approach should be adopted whereby all inadmissible
assets used to back the with-profits business should be deductible in
the calculation of the with profits capital component. If the present
approach is to be retained, the expression “assets in excess of
admissibility limits“ conveys the intention of the rules more clearly.
4.2
Final Bonus
4.2.1. The definition should be extended to cover “top-up” bonuses that apply
to instalment of with-profits annuities.
4.3
Insurer’s Capital
4.3.1 This is referred to in 3.10.29 and should be defined. See the comments
above on that rule.
4.4
Mathematical Reserves
4.4.1 The text should clarify that the With Profits Insurance Capital
Component is not part of mathematical reserves.
4.5
Net Premium
4.5.1 The definition of “ Net Premium” has a number of weaknesses not
present in IPRU(INS):

The definition should recognise that some premiums are variable,
eg step increases;

The definition should not be restricted to premiums payable for
the whole term of the policy as this is not always the case;

The definition should make clear that the net premium is
calculated as from the start of the policy (ie in the past) by
reference to the benefits and not vice versa;

Reference should also be made to disability cover;

The reference should be to 7.3.45.
5
COST BENEFIT ANALYSIS
Q6
Do you consider the analysis in Annex C to be a fair estimate of the
costs and benefits of our proposals?
5.1.
This is best answered under the two main headings.
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5.2
5.3
Reinsurance Credit Risk

This response assumes that the guidance will be expanded to
remove the need for extensive waivers as are likely to be required
by meeting the points raised in our response over intra-group and
similar situations where notification will be required but where
changes to business practice are unnecessary.
Otherwise
extensive and unnecessary costs are likely to arise;

The incidence of costs is likely to fall unevenly between
companies with some being required to do extensive analysis and
others relatively little affected;

Costs will be affected by whether regulators expect detailed
analysis of exposures and particularly contingent exposures or
whether the rules can be satisfied at a high level. In many cases
it is likely to be clear that the limits are not approached and further
detailed analysis of aggregation will not be required for credit risk
purposes although the system will still need to cover other
aspects of credit risk, eg reviewing credit rating etc, but this
should already be in hand;

Where an insurer is required to change significantly the
reinsurance programme, the costs are likely to be particularly
high;

Overall the costs are likely to be significant for some companies
and the CBA may have relatively understated the impact on them,
and

The reference to costs of derivative protection are probably
understated unless the view is taken that derivatives used for
credit risk relate to the “efficient portfolio management “ of the
reinsurance cover and are hence admissible assets.

This approach appears valid in respect of reinsurance recoveries,
ie debts due from reinsurers, but should be clarified in respect of
derivatives used to cover credit risk in respect of contingent cover,
ie where cover is supplied but no claims have been made under it
and consequently no debt due to the insurer or asset has arisen.
Life Mathematical Reserves and the With Profits Insurance Capital
Component

The main cost will be the extent to which companies respond by
raising fresh capital: this is difficult to estimate but it is important
for it not to lead unjustifiably to the closure of viable with-profits
funds;
25
5.4

The estimate of the cost of “reeducation” of analysts is
significantly too low. Companies will need to explain both the aim
of the changes and also the impact on their own product lines;

The cost of the introduction and development of stochastic and
similar modelling will be very significant although benefits will
accrue to the industry.
Resilience Reserves
5.4.1 The changes to the treatment of resilience reserves are not the subject
of consultation in this CP except to the extent that an estimate of the
cost of tax changes has been included in the CBA. This is a matter
which we propose to pursue with the Inland Revenue and are
concerned that there should be no detriment to policyholders.
Ref J/640/025G
4 November 2002
[N012609A.cleanversionFR&T.BMCH.NOTES.02]
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