Life - Articles - New approach to unit matching in Life companies

New approach required for unit matching in the Solvency II world to maximise capital efficiency, according to George McCutcheon, Director of Research, Financial Risk Solutions (FRS).

 In order to maximise capital efficiency in the new Solvency II world, Life companies will face a choice with regards to their unit matching process. Under the new regime, coming into effect in January 2016, technical provisions for unit-linked business can be lower than the face value of policyholders’ unit-linked liabilities. This is a fundamental change from the existing Solvency 1 controls, which are predicated on the face-value of policyholders’ unit-linked liabilities. Therefore new system capabilities will be required to support this new approach, which is driven by capital efficiency considerations.
 Under Solvency II, the new lower amount of technical provisions is because credit can be taken in technical provisions for the excess of future management charges over expenses. The unit-linked technical provisions will need to be matched by unit-linked assets but, for capital efficiency reasons, a Life company could choose to match the residual of the policyholders’ unit-linked liabilities with other assets.
 Net assets can be quite sensitive to movements in unit values because the amount of this credit (effectively an A-B calculation) is highly geared to unit values. The A figure (future management charges) is proportional to unit values, whereas a significant part of the B figure (expenses) would be independent of unit values. This inherent gearing effect means that a fall of x% in unit values results in a greater than x% fall in the credit.
 If the credit represents a significant part of net assets, because of falls in unit values, the Life company has a material exposure to a reduction in the amount of the credit. This exposure to falls in unit values would be compounded if the Life company chose to invest the net assets (arising from the credit) in the unit-linked funds. Furthermore such an investment policy would serve to increase the SCR (solvency capital requirement) arising from market risk.
 Consider for example where the policyholders’ unit-linked liability was 1,000 and the technical provision was 980. In effect the difference of 20 forms part of net assets.
 The life company could choose not to invest the 20 in the unit-linked funds for reasons such as:
  •   The net assets of 20 need not be exposed to variations in unit values
  •   Avoiding dual adverse effect from falls in unit values
  •   Investing the 20 in lower risk assets could reduce the SCR
  •   Capital efficiency i.e. no forced investment of 20 net assets in the unit-linked funds
 In practice, the fraction of the 20 that would not be invested would vary between 0 and 1 having regard to a number of other factors – the critical point not being the specific fraction, but rather the principle of underfunding. The required level of underfunding changes over time e.g. as unit values change or because the Life company wants to change features of its underfunding policy. This highlights the need for a rebalancing capability in the unit matching process, fundamentally changing unit-matching or box management processes.
 Therefore, should the Life Company choose this route, a systematic solution with appropriate reporting would be required to ensure maximum capital efficiency.

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