Regulation 6 Calculation of fundamental spreadI1I2
United Kingdom
The fundamental spread referred to in regulation 5 must be calculated in a transparent, prudent, reliable and objective manner that is consistent over time and based on relevant indices where available.
The fundamental spread must be calculated in accordance with paragraphs (3) to (9).
The fundamental spread must be equal to the sum of the following—
the credit spread corresponding to the probability of default of the assets, and
the credit spread corresponding to the expected loss resulting from downgrading of the assets.
For exposures to the central government of the United Kingdom and the Bank of England, where the fundamental spread would otherwise be lower than 30% of the long-term average of the spread over the risk-free interest rate of assets of the same duration, credit quality and asset class, as observed in financial markets (the “average spread”), the fundamental spread must be 30% of the average spread.
For assets other than exposures to the central government of the United Kingdom and the Bank of England, where the fundamental spread would otherwise be lower than 35% of the long-term average of the spread over the risk-free interest rate of assets of the same duration, credit quality and asset class, as observed in financial markets (the “average spread”), the fundamental spread must be 35% of the average spread.
For the purposes of this regulation—
the calculation of the “credit spread” must be based on the assumption that in case of default 30% of the market value of the assets can be recovered;
the “probability of default” must be based on long-term default statistics that are relevant for the asset in relation to its duration, credit quality and asset class;
the “expected loss” must be based on long-term statistics that are relevant to changes in the credit quality of the asset and correspond to the probability-weighted loss the insurance or reinsurance undertaking incurs where the asset is downgraded to a lower credit quality and is replaced immediately afterwards, and the calculation of the expected loss must be based on the assumption that the replacing asset meets all of the following criteria—
the replacing asset has the same cash flow pattern as the replaced asset before downgrade;
the replacing asset belongs to the same asset class as the replaced asset;
the replacing asset has the same credit quality as the replaced asset before downgrade or a higher one;
the “long-term average of the spread over the risk-free interest rate” must be based on data relating to the previous 30 years;
the methods to derive the fundamental spread of a bond must be the same for each currency and each country and may be different for government bonds and for other bonds.
For the purposes of paragraph (6)(b) or (c), where no reliable credit spread can be derived from the statistics, the fundamental spread must be equal to the portion of the long-term average of the spread over the risk-free interest rate set out in paragraph (4) or (5).
Where part of the data referred to in paragraph (6)(d) is not available or where the available data is not reliable, constructed data based on prudent assumptions may be used; and the constructed data must be based on available and reliable data relating to the previous 30 years.
Annotations
Commencement
Notes on Part 2
Textual amendments
- F1
Pt. 2 heading inserted (1.11.2024 for specified purposes and 31.12.20204 otherwise) by The Insurance and Reinsurance Undertakings (Prudential Requirements) (Amendment and Miscellaneous Provisions) Regulations 2024 (S.I. 2024/1083), regs. 1(2), 2(3)
Notes on Chapter 1
Textual amendments
- F1
Pt. 2 Ch. 1 heading inserted (1.11.2024 for specified purposes and 31.12.20204 otherwise) by The Insurance and Reinsurance Undertakings (Prudential Requirements) (Amendment and Miscellaneous Provisions) Regulations 2024 (S.I. 2024/1083), regs. 1(2), 2(3)