Solvency II - welcome relief?

The Solvency II debate has been raging on, but most are optimistic that it won’t, in its present guise, apply to pensions. Francesca Fabrizi explains

Due to come into force around the end of 2009, the objective of the Solvency II project is to establish a solvency system that is better matched to the true risks of insurers. This should enable supervisors to better protect policy-holders’ interests in accordance with common EU principles.

Stuart Lee, research actuary at HSBC explains: “Solvency II is a fundamental review of the capital adequacy regime for the European insurance industry. It aims to establish a revised set of EU-wide capital requirements which are intended to help regulators protect policyholders’ interests more effectively by making company failure less likely – reducing the probability of consumer loss or market disruption.”

But while the merits of doing this for insurance companies are widely acknowledged, there has also been a suggestion that the regime apply to pension funds in a similar fashion. While there is some support from
a number of national regulators for this to happen, the suggestion has also met with much criticism, resulting in a deluge of reports into the negative impact this could have on the pensions market in some parts of Europe. Lee explains: “In the UK, for example, the application of Solvency II to pension schemes could mean major and potentially complex changes to the statutory scheme funding requirements. In other words, another nail in the defined benefits (DB) coffin.”

Impact on DB schemes
One of the most recent pieces of research into this highly emotive topic was a report from Allianz Global Investors (AllianzGI) which launched, as part of its cooperation with the Organisation for Economic Cooperation and Development (OECD), a study addressing the impact of risk-based funding requirements on DB pension schemes.
Juan Yermo in the Financial Affairs Division at the OECD explains: “At the OECD we have been concerned about the disappearance of final pay schemes and the emergence of pure DC arrangements and we are trying to assess to what extent different regulations are playing a role in this shift, what kind of funding regulations make sense for the different pension deals and what a risk based funding regulation would do to funding requirements.”
The findings weren’t hugely dissimilar to those of previous studies and concluded that Solvency II, if applied in its current guise to DB schemes, could force sponsors to increase funding, change asset allocations and even ultimately close their schemes altogether.

What was surprising, however, says Brigitte Miksa, head of pensions international at AllianzGI, was the extent to which demands would be increased among some plans. “The study had two main results showing that if Solvency II in its existing form were to be applied we would have an increase in capital requirements that is quite remarkable and it would also to lead to dramatic changes in asset allocation: the risk free assets would remain and investments in
equities and hedge funds would dramatically decrease.

“We would also see LDI becoming even more important.”

As the study highlights, DB pension scheme liabilities appear much larger under Solvency II than under the current IAS 19 regulations, the international pensions accounting standard. For a traditional final salary DB scheme, for example, a scheme that is deemed to be fully funded under IAS 19 would only be 64% funded under Solvency II. The cost of funding DB schemes is directly linked to the solvency regime, which establishes the level of funding deemed necessary to meet current and projected future liabilities. Therefore any tightening in the solvency rules will have a significant and potentially negative impact on the sponsor's costs and risks.

In April, the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) also published a report stating that Solvency II for pension funds was not an appropriate course to pursue and could threaten DB provisions.

Paul Kelly, principal at Towers Perrin, explains: “In its report, CEIOPS is effectively saying that Solvency II is not the answer to pensions institutions’ problems. This probably reflects a lot of debate that has been happening on Solvency II in the last few months and the recognition that there are significant differences between pensions schemes and insurance companies.”

Similarly, earlier this year the European Commission gave its strongest indication yet that Solvency II rules were unlikely to be applied to pension funds, officials acknowledging that heightened capital and asset allocation requirements on pensions funds could lead to DB closures.

The CEIOPS survey does, however, highlight a lot of the problems with the current situation and reinforces the point that something does needs to be done. Kelly continues: “CEIOPS does state that comparable member protection is needed to ensure a level playing field in all countries and while it has said the integral application of Solvency II is not
the way forward – which makes sense as one of the fundamental differences between pension schemes and insurers is that with the former you have the linkage back to an employer that in some countries sits behind the pension scheme – they do acknowledge that we still have the problem of regulatory arbitrage and that something needs to be done to create a level playing field across Europe.”

So while it appears a popular argument that Solvency II shouldn’t, in its current guise, apply to pension schemes, why is the debate continuing? The argument goes back to the fact that a pension in one member state could be very different to the next. Kelly says: “One problem is that some countries apply insurance company rules to pension schemes already so Solvency II will apply for them anyway. Countries such as France and Sweden treat pension schemes like insurance companies whereas countries like the UK, where there is recognition of the employer’s covenant, don’t and so the problem again comes back to the question: how do you achieve a level playing field?

“In other countries, such as Lithuania or Slovenia, the nature of occupational pension provision is DC so this doesn’t apply to them anyway. So there are groups of countries where there is real concern, and others where it doesn’t matter.”

What of the future?
While all indications appear to be pointing in the direction of Solvency II not applying to pensions in its current form, the debate still rages on, and the pressure is on to find a solution. This goes hand in hand with the debate surrounding the IORP review and whether the time has come for a closer look in this area. At the time of going to press, an update from the European Federation for Retirement Provision (EFRP) on this topic was imminent, although in recent months it has argued strongly against any such review so soon after the IORP’s initial implementation.

Whatever the outcome, the most important challenge to overcome are the fundamental differences inherent in the European pension space. As Miksa highlights, the definition of a pension per se differs across Europe: “We have different legal concepts that have to be taken into account, as well as the specific risk characteristics of pensions in the newer member states."

We are still a long way from finding true harmony.