Don't discount Solvency II

Solvency II was written for insurers, but its risk management and valuation ethos can benefit UK pension schemes, writes John Dewey

4 minute read

picture of a man with a suit with his hand out

Of all the European Union regulations that the UK might look to repeal or revamp when it leaves the bloc, Solvency II already looks likely to be high on the list. On September 13, the influential Treasury Committee launched an extensive inquiry into the rules1, declaring that Brexit “provides an opportunity for the UK to assume greater control of insurance regulation”.

This will likely be seen as good news to UK pension schemes, which have long resisted calls to replicate Solvency II for the pensions industry. Proposed moves to amend the Institutions for Occupational Retirement Provision (IORP) directive and implement a similar risk-based (Holistic Balance Sheet) regime for defined benefit pension schemes met with strong objections as far back as 2010.

Given the significant challenge of underfunding among many UK pension funds, replicating Solvency II could clearly lead to unrealistic capital requirements. It now seems unlikely to come to fruition, particularly in light of the extra leverage the UK should have over its regulations after Brexit. Nonetheless, discounting Solvency II altogether might be a mistake – some elements of the regulation can add value for pension funds, and an understanding of its impact on insurance investment allows funds to identify investment opportunities.

Implemented in January 2016 after a long gestation period, Solvency II was designed to improve and harmonise supervision of insurers across Europe and give policyholders greater protection and confidence. Like the Basel framework for banks, the regulation is split into three pillars: minimum capital requirements; risk management, governance and supervision; and finally reporting and disclosure.

Solvency II was always designed for insurers rather than pension funds, but some countries drafted similar requirements for pension schemes long before the European rules were implemented. In the Netherlands, for example, a more disciplined and consistent approach to pension fund risk management and reporting has had a positive impact on the country’s financial system over the past decade. Under the so-called Financial Assessment Framework (FTK), implemented in 2007, a pension fund’s capital must amount to at least 105% of its liabilities, and funds must hold sufficient additional capital buffers to protect them from financial shocks.

In the event this so-called coverage ratio falls below 105%, the fund must submit a recovery plan to De Nederlandsche Bank, the Dutch supervisory authority, with strict rules on indexation (not allowed if the funding ratio falls below 110%) and benefit reductions, if required. Meanwhile the Netherlands Authority for the Financial Markets monitors the behaviour of pension funds to ensure relevant information is disclosed to members on a timely basis.

Adopting this risk-based framework early on has enabled the Dutch pensions market to navigate the difficult market conditions and volatility of recent years in better shape than some other countries. While the same framework may not work for all countries, there are clearly elements of a risk-based approach that can bring tangible benefits to pension funds. The benefits of this consistent measurement and disclosure were recently highlighted by the International Monetary Fund (IMF).

In its latest Global Financial Stability Report2, published in October 2016, the IMF stated: “In Europe, regulations should be strengthened to ensure a common framework for risk assessment and enhanced transparency. This means valuing assets and liabilities on a market-consistent basis to facilitate standardized reporting and risk analyses, such as stress testing. Greater consistency would boost transparency, including by ensuring regular public disclosure of balance sheet metrics and risk analyses.”

Setting aside the stringent capital requirements of Solvency II, which would require huge capital injections from corporates, the underlying risk management philosophy is worthy of closer consideration. Specifically, having a simple, consistent and transparent mechanism for the measuring of liabilities is a cornerstone of Solvency II and would be a positive step forward for the pensions industry.

Across Europe, a range of methodologies are used to measure pension fund liabilities today, which can create a distorted and misleading picture for investors. In the UK for example, there are diverse ways in which pension funds value their liabilities. While corporate accounting uses corporate bond discount rates, funding valuations allow schemes some subjectivity in setting their discount rate.

This enables pension schemes to take into account their current funding situation and future expectations, but it creates a perverse situation in which a fund can take more risk, target higher returns, and report a lower liability valuation by discounting liabilities at a higher rate. A market-consistent valuation such as the methodology enshrined in Solvency II may result in less favourable valuation results in the short-term, but it would be a more realistic and objective measure that could be applied consistently and transparently across the industry.

It remains to be seen exactly what will come of the Treasury Committee’s review of Solvency II, and it could be a long time before there is any concrete move to change the framework governing pension funds in the UK. Nonetheless, it is important for the industry to remember that some of Solvency II’s provisions may work for pension schemes.    

In the shorter term, the implementation of Solvency II in the insurance world has created new investment opportunities for pension funds that may not be immediately obvious but are worthy of consideration. Heightened capital requirements are driving insurers towards secure long-dated fixed-rate assets that closely match their liabilities, but assets with pre-payment risk don’t meet Solvency II requirements and should therefore be more readily available to pension funds.

Structuring a portfolio to avoid targeting the same long-dated fixed rate assets as insurers could help pension funds avoid being part of the herd. Shorter-dated assets can provide a significantly deeper pool of opportunities to exploit liquidity premia and diversified credit exposure. Another potential option can be found in assets, such as real-estate debt, that may carry flexibility for borrowers to pre-pay towards the end of a contract. Even if the pre-payment window is relatively short in comparison with the life of the asset, such assets are popular with borrowers but now less likely to be bought by insurers if they can’t get the necessary capital treatment under Solvency II. While pension funds may not need to comply with Solvency II, they should understand the nuances of the rules so that they can target these private asset investment opportunities.

Finally, there has been heavy speculation in recent years over the impact of Solvency II on pension fund buy-outs, with the expectation that it would become more expensive for pension funds to discharge a chunk of their liabilities to insurers. In reality, this is still a highly competitive market and through careful management of their assets and liabilities, many insurers have managed to maintain similar pricing since the implementation of Solvency II. Pension funds should not be deterred from considering buy-outs, however, as opportunities still exist.

There is no doubt that Solvency II has dramatically changed the landscape for European insurers, but it would be wrong for pension funds to dismiss the regulation in its entirety. Not only are there elements of the framework that could ultimately benefit pension funds, careful scrutiny of the rules and the impact they have had so far could also yield unexpected business and investment opportunities.


1 Treasury Committee launches inquiry into EU Insurance Regulation,, 13 Septemebr 2016

2 Fostering stability in a low-growth, low-rate era, October 2016


Related views

Important information


Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (AIGSL). Unless stated otherwise any views and opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable, but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this material, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. Some data shown are hypothetical or projected and may not come to pass as stated due to changes in market conditions and are not guarantees of future outcomes. This material is not a recommendation to sell or purchase any investment.

The information contained herein is for general guidance only. It is the responsibility of any person or persons in possession of this information to inform themselves of, and to observe, all applicable laws and regulations of any relevant jurisdiction. The information contained herein does not constitute an offer or solicitation to any person in any jurisdiction in which such offer or solicitation is not authorised or to any person to whom it would be unlawful to make such offer or solicitation.

In Europe, this document is issued by Aviva Investors Luxembourg S.A. Registered Office: 2 rue du Fort Bourbon, 1st Floor, 1249 Luxembourg. Supervised by Commission de Surveillance du Secteur Financier. An Aviva company. In the UK, this document is by Aviva Investors Global Services Limited. Registered in England No. 1151805. Registered Office: St Helens, 1 Undershaft, London EC3P 3DQ. Authorised and regulated by the Financial Conduct Authority. Firm Reference No. 119178. In Switzerland, this document is issued by Aviva Investors Schweiz GmbH.

In Singapore, this material is being circulated by way of an arrangement with Aviva Investors Asia Pte. Limited (AIAPL) for distribution to institutional investors only. Please note that AIAPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIAPL in respect of any matters arising from, or in connection with, this material. AIAPL, a company incorporated under the laws of Singapore with registration number 200813519W, holds a valid Capital Markets Services Licence to carry out fund management activities issued under the Securities and Futures Act (Singapore Statute Cap. 289) and Asian Exempt Financial Adviser for the purposes of the Financial Advisers Act (Singapore Statute Cap.110). Registered Office: 1 Raffles Quay, #27-13 South Tower, Singapore 048583.

In Australia, this material is being circulated by way of an arrangement with Aviva Investors Pacific Pty Ltd (AIPPL) for distribution to wholesale investors only. Please note that AIPPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIPPL in respect of any matters arising from, or in connection with, this material. AIPPL, a company incorporated under the laws of Australia with Australian Business No. 87 153 200 278 and Australian Company No. 153 200 278, holds an Australian Financial Services License (AFSL 411458) issued by the Australian Securities and Investments Commission. Business address: Level 27, 101 Collins Street, Melbourne, VIC 3000, Australia.

The name “Aviva Investors” as used in this material refers to the global organization of affiliated asset management businesses operating under the Aviva Investors name. Each Aviva investors’ affiliate is a subsidiary of Aviva plc, a publicly- traded multi-national financial services company headquartered in the United Kingdom.

Aviva Investors Canada, Inc. (“AIC”) is located in Toronto and is based within the North American region of the global organization of affiliated asset management businesses operating under the Aviva Investors name. AIC is registered with the Ontario Securities Commission as a commodity trading manager, exempt market dealer, portfolio manager and investment fund manager. AIC is also registered as an exempt market dealer and portfolio manager in each province of Canada and may also be registered as an investment fund manager in certain other applicable provinces.

Aviva Investors Americas LLC is a federally registered investment advisor with the U.S. Securities and Exchange Commission. Aviva Investors Americas is also a commodity trading advisor (“CTA”) registered with the Commodity Futures Trading Commission (“CFTC”) and is a member of the National Futures Association (“NFA”). AIA’s Form ADV Part 2A, which provides background information about the firm and its business practices, is available upon written request to: Compliance Department, 225 West Wacker Drive, Suite 2250, Chicago, IL 60606.