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
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 rules, 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 Report, 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.
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