Peter Caslin argues that the increasing complexity of governance of unit-linked funds demands a greater need for actuarial skills
The Financial Conduct Authority's (FCA) thematic review of unit-linked funds is very significant for the life insurance industry. It also underpins the need for actuarial skills in the management and governance of unit-linked funds. Would there be real benefits for retail customers if actuaries had a more substantive role in the management and governance of unit-linked funds?
Administering unit-linked funds is a complex business activity. Complexity arises for many reasons e.g. the multiple layers of funds in a tiered fund structure, use of derivatives, ensuring compliance with investment mandates, multi-currency funds and assets, determining provisions for tax and placing value on tax losses in unit pricing, making allowance for dealing costs, moving between cancellation and creation unit pricing bases, monitoring performance of mirror funds linked to a single external collective fund, fund mergers, deferral of unit transactions due to market disruption, the use of discretion in unit pricing and unit matching, timing issues for business processes, error correction and compensation, compliance monitoring, risk management processes, securities lending issues and monitoring business process outsourcing, to name a few!
Whilst much of this complexity is common to both the mutual funds industry (e.g. OIEC's, Unit Trusts, UCITS funds etc.) and internal unit-linked funds of life companies there is a unique challenge for life companies in managing the equity issues which arise in the consistency of timings of unit allocation to policyholders, asset unit creations in the fund and the timing of the purchase of the underlying assets in the fund (particularly for mirror funds).
This challenge arises due to the conflict between legacy policy administration systems and legacy internal/outsourced fund administration systems on the one hand and on the other hand the demand from financial advisors that their clients are allocated units (and their remuneration be paid) based on the next available unit price. This conflict effectively means that most life companies cannot operate on a true forward pricing basis for policyholder transactions.
Objectives of Thematic Review
The FCA thematic review is assessing whether:
a. firms have adequate systems and controls in place to ensure that funds are administered and managed fairly and in accordance with customer expectations;
b. assets backing unit-linked policies are appropriate for policyholders; and
c. policyholder benefits are calculated fairly and accurately.
This article looks at the challenge posed by the inability to operate on a true forward pricing basis in the context of (a) and (c).
Where Actuaries can add Value
Whilst in some life companies actuaries might not have a central role in the management and governance of unit funds, they do have particular relevant expertise that can add value.
Examples include:
Life companies must act in accordance with the FCA's Principles for Business including the need to comply with "Treating Customers Fairly (TCF)" requirements. Whilst the 2012 ABI "Guide of Good Practice for Unit-Linked Funds" provides guidance to firms on what TCF means in the context of unit-linked fund governance, actuaries can add value by applying mathematical rigour to such guidance.
Advising on tax provisioning and in particular on placing value on tax losses in the unit pricing of taxed life company internal funds.
Advising on issues arising from the use of tiered fund structures.
Advising on the how life companies manage the challenge arising from their inability to operate on a true forward pricing basis.
Advice from ABI's Good Practice Guide and Thematic Review Issues
The thematic review is assessing whether providers of unit-linked funds are managing them in line with the stated investment objectives. Consider a mirror fund where a life company's internal unit-linked fund mirrors an external collective fund, for example an OEIC, where the stated investment objective might be that the unit price of the internal fund should broadly track that of the OEIC, adjusted for any additional management charge. The ABI 2012 guide to managing unit-linked funds recommends that processes are designed to ensure that funds designed to track the performance of an underlying asset do so in such a way as to minimise the risk of any significant distortion or deviation.
In order to achieve this for a mirror fund it is necessary to:
(a) purchase the units in the external OEIC at a given valuation point;
(b) use the value of the OEIC at that same valuation point to calculate the unit price of the internal unit-linked fund; and
(c) create units in the unit fund, using the unit price in (b), equal to the value of the units purchased in the OEIC.
Let's call the process described above 'Matched Forward Pricing'. The key point in Matched Forward Pricing is that the underlying asset, e.g. the OEIC, has to be purchased in advance of the matched units being created in the internal unit-linked fund.
The problem for many life companies is that, because of their legacy systems, the first point in time that the fund administration team know about policyholder cashflows to be invested in a fund is the day after the policyholder has been allocated units in the fund. This means that the valuation point used for calculating the unit price at which units are allocated to a policyholder is at least one day in advance of the valuation point used in Matched Forward Pricing. The difference in the valuation point used to allocate units to policyholders and that used in Matched Forward Pricing is a gain/loss to the life company.
This creates an implicit box position for the life company where the units in issue in the fund are less than (in the case of a policyholder inflow) the units allocated to policyholders on the policy administration system. The calculation of the gain/loss on such box positions will be required for risk management purposes and also for the company's analysis of surplus. Most of the legacy fund administration/unit pricing systems used by life companies cannot provide this information.
Fundamental to the thematic review is that policyholder benefits are calculated fairly and accurately and a key requirement is that the fund administration processes are structured in such a way that there is equity in unit pricing. Mirror funds represent a specific example of the objective that life companies have of ensuring that inflows into a unit-linked fund shouldn't materially impact on existing unitholders. In this context, monies into the fund include not only customer inflows but also inter-fund cross-holding transactions. Using Matched Forward Pricing achieves this objective.
The term 'forward unit pricing' is often used in the life industry and is generally used to distinguish from 'historic unit pricing' where a policyholder could potentially select against the life company by reviewing market movements since the historic pricing date. While forward unit pricing may eliminate anti-selection it does not necessarily lead to equity in unit pricing unless Matched Forward Pricing is used.
The ABI Guide doesn't specifically recommend Matched Forward Pricing but section 4.3.1 refers to:
"Avoiding any material geared exposure to market movements of the fund or policyholders by considering the relative timings of net policyholder unit transactions and the related asset purchase or disposal".
Irrespective of what method is used, however, there has to be an objective test of whether the fairness principle is being met. Clearly the fairness criteria have to be subject to some test of materiality. So either an approach such as Matched Forward Pricing is adopted, which clearly meets the fairness test, or else if an approach is being used that could fail the test in certain circumstances, then control procedures are required to identify, monitor and redress such circumstances. Actuaries could add value by advising on such control procedures and on the appropriate tolerances to be used.
Conclusions
The current system in the UK does not involve a detailed set of rule-based requirements for the administration of unit-linked funds. Instead, the FCA has set out a framework of Principles for Business which firms must apply and interpret. Life companies have some unique challenges administering unit-linked funds where actuaries can add value in ensuring compliance with these Principles.
It will be interesting to see what the FCA's key findings from the thematic review will be, and whether this will lead to any regulatory changes.
Peter Caslin is a qualified actuary and the CEO of Financial Risk Solutions, a provider of unit pricing and fund accounting software specifically designed for the Life Assurance and Pensions industries.
