Unit-linked business – it just keeps getting harder

Under Solvency I, unit-linked business has been relatively straight forward to run for life insurers. You match the face value of the liabilities with the same assets, hold a sterling reserve to cover any excess expenses and recognise the Value of In-Force (VIF – i.e. the future profits) only in Embedded Value reporting, thus maintaining a stable IFRS profitability. If you want to recognise the future margins in the VIF in your statutory reporting, you can enter into a securitisation or reinsurance transaction.

Sure, it’s a bit like the proverbial swan and under the surface, there are a lot of procedures, systems and governance to establish and follow to ensure TCF and these were the subject of a FCA thematic review in October 2013 but generally firms haven’t had to face too many tricky decisions when running a unit-linked book.

However, Solvency II threatens to change all of this. Firstly, the rules remove the need to match the face value of the liabilities (you now only have to match the lower Best Estimate Liability (BEL) with units and can invest the VIF freely).  This introduces the need to make decisions on investment strategy and potential use of risk mitigations such as derivatives and reinsurance, depending on your relative desires to minimise capital, maximise returns or minimise statutory or accounting volatility. 

For those firms using the standard formula, only an equity down scenario is required to be tested under the market risk SCR. Under this scenario, the optimal capital strategy is to hold your VIF in cash as then the units held will match the BEL and you avoid market risk stress capital (the lapse risk stress capital is independent of your investment strategy for the VIF).

There may, however, be a number of reasons why a firm might not want to do this, e.g. systems, complexity, accounting volatility.  Also, if you are investing your VIF in cash, then you are exposed to an equity up and mass lapse scenario, which is not covered in the standard formula.  You would probably have to test this scenario and hold extra capital under the ORSA and in a worst case scenario, you may be forced into a partial internal model for your unit-linked business.  

So maybe it is better just to match the face value with units and accept the market risk capital charge.  In this case, you will be required to calculate the equity, spread, interest rate and counterparty exposure components of the market SCR based on your holdings of the units in excess of the BEL.

Unfortunately, that calculation has just got harder if your funds are linked to external funds.  The final report on CP 14/36 on Guidelines on the look-through approach issued by EIOPA on 27 November 2014 rejects the call to exclude unit-linked products from the look-through principles.

This means that companies will need to ensure they comply with the look-through guidelines.  I will be issuing a blog summarising these in the near future.

Whilst a lot of focus has been concentrated recently on annuity business and the matching adjustment, it is clear that companies need to ensure that they don’t forget to focus enough energy and time on how to deal with their unit-linked books.