Life insurance (SA2): valuation, capital and product judgement
SA2 tests whether you can apply life insurance principles to realistic scenarios: product design, pricing, valuation, capital, risk management and communication. The life domain concentrates on how liabilities are valued, how capital is held against them, and how products such as annuities, protection and with-profits are managed within UK regulation.
Core rules and concepts
- Products and risks: without-profit protection carries mortality, morbidity and expense risk; annuities carry longevity and reinvestment risk; unit-linked business transfers investment risk but retains expense, persistency and operational risk; with-profits pools investment and other risks and shares surplus through bonuses.
- Solvency II/UK balance sheet: technical provisions = best-estimate liability (BEL) + risk margin. BEL is the probability-weighted present value of best-estimate cash flows; the risk margin is the cost of holding SCR over run-off. SCR is calibrated to a 99.5% one-year VaR; MCR is a lower floor.
- Matching adjustment (MA): for eligible fixed-cashflow liabilities such as annuities, the discount rate may be increased by the asset spread over risk-free less the fundamental spread. This lowers BEL and capital, but requires ring-fenced, tightly matched portfolios and strict eligibility.
- With-profits: the WPICC, PPFM, smoothing, inherited estate and 90/10 sharing rules govern how surplus is distributed. FCA Consumer Duty and fair treatment constrain discretion.
Worked example
An insurer has assets £1,200m, BEL £900m, risk margin £50m and SCR £180m. Own funds = 1,200 − 900 − 50 = £250m; coverage = 250/180 = 139%. If assets fall 10% to £1,080m and other items are unchanged, own funds fall to £130m and coverage to 72%. The insurer must restore capital, de-risk or reduce SCR. The reasoning shows balance-sheet gearing to asset shocks and why ALM matters.
Traps that cost marks
- Calling BEL a prudent reserve; prudence belongs in the risk margin and SCR.
- Applying MA to ineligible liabilities or ignoring the fundamental spread.
- Treating the with-profits estate as free surplus rather than governed by the PPFM.
- Omitting policyholder behaviour (lapses, paid-up rates) from cash flows.
- Forgetting that reinsurance changes both BEL and SCR, not only premium cost.