Unit Shorting:
A capital-efficient strategy for unit-linked portfolios
In today’s competitive insurance markets, insurers are constantly seeking innovative strategies to optimise their capital efficiency. One such strategy is unit shorting, offering liquidity benefits and reduced capital requirements without impacting policyholder outcomes.
In this article, Luke Spiers, Financial Solutions Lead at the Hannover Re UK Life Branch explores the concept of unit shorting, its benefits and alternative structures. The article also highlights the potential role of reinsurance, particularly mass lapse solutions, in managing the liquidity and capital implications of unit shorting.
What is unit shorting?
Before Solvency II, insurers were required to hold assets at least equal to the surrender value of policies. The surrender value for unit-linked business is based on the unit price of investment fund(s) chosen by the policyholder.
Under Solvency II, the insurer is required to hold assets at least equal to the Technical Provisions. The Technical Provisions include the present value of future annual management charges and are thus normally lower than the surrender value of the policies.
Crucially, the policyholder’s benefits are totally unaffected whether the insurer holds assets equal to the surrender value (unit matching) or the lower Solvency II Technical Provisions (unit shorting).
Why are we talking about unit shorting?
When Solvency II was introduced the industry’s focus was on implementation. Now that Solvency II is well-established, attention has shifted towards capital efficiency and unlocking value from the changes introduced. As a result, unit shorting has increasingly been implemented or considered as a potential solution. This is especially the case as unit shorting can be beneficial to shareholders without negatively impacting policyholders.
Advantages & disadvantages of unit shorting
A key advantage of unit shorting is the ability to disinvest from equities into cash, which immediately improves the insurer’s liquidity position. It also significantly reduces the required equity Solvency Capital Requirement (SCR).
This is demonstrated in the following illustrative example, where we have the following values:
- Assets: 1,000 invested in equities
- Unit liabilities: 1,000
- Present value of future management charges: 150
- Fixed expenses: 50
If the insurer adopts unit matching, and assuming a 40% equity stress, the equity SCR is 60.
If the insurer instead adopts unit shorting, holding the excess above Solvency II Technical Provisions in cash, the equity SCR reduces significantly to 20.
While unit shorting is normally considered for the liquidity and capital benefits provided, there are various advantages and disadvantages, compared to unit matching:
Alternative structures
Alternative approaches to unit shorting have been considered within the market, such as using derivatives (either directly or via a reinsurer) to synthetically replicate the disinvested assets.
This provides a hybrid benefit, and is most effective when the primary goal is to increase liquidity:
- It retains the liquidity benefits from disinvesting, alongside the increased liquidity risk if lapses increase.
- It increases the equity SCR back to the unit matching position.
For example, in early 2025 amid market volatility due to new US tariffs, this approach was tested using a combination of buying call options and selling put options. The result: a trade-off for the insurer between receiving a net premium from the derivatives (dependent on market conditions) and holding additional Equity SCR.
Whether this trade-off is worthwhile will depend on the insurer’s individual situation. This approach won’t align with the priorities of many insurers, particularly those focused on minimising capital requirements and operational complexity as it:
- Offers a low return on capital,
- Introduces material operational complexity, and
- Increases Solvency II capital requirements.
Potential role for reinsurance
While reinsurers can help synthetically replicate the disinvested asset exposure, this is only beneficial in specific circumstances.
A more impactful role for reinsurers lies in managing mass lapse risk, typically one of the largest risks and SCR components for unit linked business. Unit shorting increases liquidity risk in the event of higher lapses, as the insurer holds fewer assets than the unit value and must find liquidity elsewhere to fund surrender payments.
Mass lapse reinsurance can be a particularly useful solution as it both:
- Improves capital efficiency (similar to unit matching).
- Provides liquidity through a reinsurance claim, mitigating the increased liquidity risk introduced by unit shorting.
Potential future market developments:
The focus on capital efficiency and capital-light products is likely to keep unit shorting on the industry’s radar. Adoption will naturally vary based on the insurers size and portfolio composition:
- Larger insurers with significant unit linked portfolios have often already implemented unit shorting, a trend that is likely to continue.
- Smaller insurers are likely to remain cautious about implementing unit shorting, given the operational complexities involved.
Ultimately, whether insurers choose to:
1) Continue unit matching,
2) Introduce unit shorting, or
3) Explore a hybrid approach using derivatives.
Will depend on their view of the reward for equity risk within the Solvency II framework. If they don’t believe that they are adequately rewarded, then they may prefer to minimise their equity exposure by adopting unit shorting or equity hedging programmes.
With extensive global experience, Hannover Re supports clients in writing mass lapse reinsurance solutions that enhance capital efficiency and liquidity management. Through our solutions, we enable organisations to address the challenges facing their business, not just by managing risk, but by achieving client-specific financial, capital and strategic objectives.
If you are exploring capital efficient strategies for your unit-linked portfolio, Hannover Re is well-positioned to support you with bespoke, regulator-aligned solutions tailored to your needs.
Contact
Luke Spiers Financial Solutions Lead
Hannover Re UK Life Branch
luke.spiers@hannover-re.com
+44 7919887928
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