Companies may be inclined to underfund unit linked liabilities for Solvency II

A consequence of the move to Solvency II is that unit linked life companies may be well advised to underfund their unit liabilities in the future. According to recent articles in the Actuarial Post by George McCutcheon of Financial Risk Solutions (FRS), doing so will release cash, minimise the volatility of own funds and reduce the market risk solvency capital requirement (SCR).

At present companies hold sufficient assets to match their UL liabilities, but under Solvency II the requirement is to match the “technical provisions” in respect of unit linked benefits. As technical provisions will consist of the best estimate liability plus a risk margin they will, for profitable business, normally be less than the face value of the liabilities. It is not certain precisely how regulators will define technical provisions in these circumstances and McCutcheon shows two possible interpretations allowing different levels of funding. In any case, by underfunding the face value of the liabilities and holding the balance (essentially the Present Value of Future Profits) in cash the company’s own funds are less exposed to market falls and in addition the market risk element of the SCR will be reduced. In his latest article McCutcheon further shows that underfunding is also the best way to protect own funds in the event of excess lapses (which themselves are more likely with market falls).

Underfunding seems to make sense but there are issues arising. The unit-matching process will be more complex as the proportion of the face value of units to be matched will vary by fund and by time. The fund administration system would need to be developed to provide the necessary reporting and analytical requirements and, because the proportions are likely to be recalculated only every 3, 6 or 12 months, a risk management framework would need to be built around it. There are also accounting issues to the extent that IFRS differs from Solvency II in the treatment of PVFP.

Milliman have also published articles on this topic and the Institute and Faculty of Actuaries have had a Working Party looking at the capital implications of Solvency II. It does seem as though there are significant benefits for companies in underfunding liabilities, but there is some regulatory uncertainty and considerable administrative effort. In addition not all CFOs will be delighted with having more cash to manage in the present interest rate environment. It is likely that companies will move cautiously on the matter until all the implications are worked out.
- John Lyons