George McCutcheon, director of research at Financial Risk Solutions (FRS), explains how the introduction of Solvency II will result in a fundamental change in how life companies operate their unit-linked matching processes
For life insurers with large unit-linked portfolios, choosing an appropriate unit-matching process will be an important part of their capital management programme.
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There will also be the potential to release cash from the unit-linked funds for other capi¬tal purposes, with the elimination of unnecessary forced investment into the unit-funds being a very welcome development for finance directors of life insurers.
This article details the practical issues involved and the systems required to operate the business processes with appropriate risk management and reporting.
Solvency II will result in fundamental change to how life companies operate their unit-linked matching processes, since they will no longer be required by regulations to match the full face value of unit-linked liabilities.
The regulatory criteria for unit matching is as per Article 132(3) of the Solvency II directive, which requires that the technical provisions for unit-linked contracts are matched by units.
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By GlobalDataHowever, under Solvency II, the investment policy for the amount (‘excess value amount’) representing the excess of the face value of the unit-linked liabilities over the Solvency II technical provisions is not prescribed by regulation.
Life companies will decide the investment policy for the excess value amount by taking into account a number of criteria, including:
- Capital efficiency, e.g. avoiding unnecessary forced investment into the unit funds
- Is the unit-matching process driven by Solvency II reporting or IFRS reporting consid-erations?
- Is there an objective to minimise volatility in Solvency II net assets arising from variations in unit-linked values?
- Is there an objective to minimise the market risk Solvency Capital Requirement (SCR) on the excess value amount?
- Is there an objective to minimise volatility in the SCR coverage ratio?
Consider the example in Table 1. Under Solvency II, the required technical provi¬sions in this example are £990, but it is arguable that for the purposes of applying Article 132(3) the technical provisions could be interpreted as £1,000-40 = £960, based on the face value of units, less present value in force (PVIF) of future management charges.
Question: Is the excess value amount £10 or £40? This depends on how the Pruden¬tial Regulatory Authority defines technical provisions for close matching purposes under Solvency II, which is an industry issue that has been highlighted by the Actuarial Profession’s Linked Match¬ing Considerations Working Party to the PRA.
The effect on Solvency II basis own funds (assuming no change in the risk margin and that cash is held in respect of amounts not invested in the unit-linked funds) is shown in Table 2 for various alternative unit-matching approaches.
What this illustrates is that if a life company wishes to minimise the volatility of their Sol¬vency II-basis own funds (subject to changes in the risk margin), the optimum unit-matching approach is based on £960, i.e. the excess value amount is not invested in the unit funds.
By definition, this approach would also mean that the market risk SCR on unit-linked assets is minimised (unless the life insurer chooses to hold more unit-linked assets, e.g. in respect of the risk margin or to match the SCR for lapse risk).
In practice, this means that the unit-matching process under Solvency II will be based on investing a proportion of the amounts that would be invested in units in the Solvency I world. Different insurers will place different weights on the various criteria, and so the required proportions will vary by insurer.
Impact
A key impact of this is that life companies will require fund administration systems with capabilities to match to a proportion of the unit liability, where the required proportion varies by fund and over time.
And these varying proportions over time will require rebalancing capabilities. The fund administration system should record the two components of the unit-matching separately, by firstly matching the face value of units and secondly the underfunding (e.g. in respect of the PVIF of future management charges or whatever).
This would then enable the computation of the profit/loss on the underfunding for IFRS reporting purposes. From the analytics capabilities of the fund administration system, the life company would know at any time the size of the underfunding positions and the gains or losses on those positions, which the life com¬pany needs to know at any given time.
In conclusion, under Solvency II, the elimina¬tion of unnecessary forced investment into the unit-funds should be very welcome news for finance directors of life insurers.
However, it is crucial that the reporting capa¬bilities of their fund administration system – for validation purposes and cross-reporting to the actuarial function – facilitates the ability to accurately manage the unit-linked matching process and the overall capital management programme.
