March 2008 37www.the-actuary.org.ukin any solution that follows would be the potential impact on employers8217 appetite for occupational pensions involving any form of guarantee, the consequential level of future pension provision and its implications for social policy objectives. Modi64257 ed Solvency II?The European Parliament is known to favour the principle of 8216same risk, same capital8217, so regardless of how the problems of harmonisation are resolved, it is conceivable that a capital-focused approach might be developed around the high-level principles of Solvency II, but with the detailed rules speci64257 cally tailored for pensions. For individual pension plans, the capital adequacy bar would most probably be raised to re64258 ect more speci64257 cally the risks taken, particularly in the design of the pension plan, its demographic pro64257 le and its assets and funding strategies. Successful implementation would depend on the 64258 exibility retained in the rules for risk mitigation through management actions 8212 for example, bene64257 t reductions, conditional indexation, long lead times for education and planning, and a gradual phasing-in of any substantial new 64257 nancial commitments. Some thought would also need to be given to the nature and quality of assets backing the solvency capital. Here it would be necessary to recognise differences between insurance company and pension scheme balance sheets. With the latter, the assets you see on the balance sheet are just part of the capital backing the promise, since in most cases (excluding the so-called 8216regulatory own funds8217) there is a lifeline back to the sponsoring employer. In practice, therefore, the employer8217s business is already providing solvency capital. In a uniformly quantitative approach, however, there would be questions about the quality of the employer8217s covenant and the extent to which it can be enforced by the pension scheme. Any attempts to put a value on this 8216credit8217 would raise complex, but not insurmountable, problems. It might be tempting to bypass these problems by requiring all solvency capital to be held on the pension scheme8217s balance sheet. In countries like the UK, this would raise the spectre of trapped capital which would be fundamentally unsound, since solvency capital is not the same as liabilities, and shareholders do need to have access to it without penalty.A further credit to consider would be against security 8216purchased8217 from external institutions such as the Pension Protection Fund, although the arguments here may not be so clear cut. Something different?It has been said that Solvency II is not just about capital adequacy, but also about changing behaviours. Evidence from the UK insurance industry shows that the risk-sensitive individual capital assessment regime has indeed led to better decision-making, better engagement with company boards, better quanti64257 cation and allocation of capital, more innovation, and generally better risk management. The pensions industry could certainly bene64257 t from more of this if it came with an affordable price tag.If promoting the right behaviour is the primary objective, then a Solvency II-type approach may not be the only way. Take the example of the UK pensions industry two years ago. It does not have any hard quantitative prescription, but sponsors across the country will tell you that it is no push-over. Trustees and actuaries will tell you that it has led to a better awareness of the risks taken, including the employer8217s credit risk, with funding and investment strategies set in tandem to balance the risks involved, and their affordability, with member security. And the Pensions Regulator will tell you that it is in the business of risk-based supervision with clearly articulated expectations and checks, aimed at promoting the right behaviours. Indeed, evidence is also emerging of funding targets which are at times higher than those which might have otherwise prevailed. All this has been achieved through strong regulatory and scheme-based governance, with appropriate guidance and checks. While not a recipe for a uniform level of security, it does provide some lessons on how the high-level objectives of Solvency II might be encapsulated within a principles-based funding and solvency framework 8212 one that recognises the essential differences between insurance and pensions, as well as the different styles and structures for pension provision within EU countries. The detailed rules could then be devised on a bespoke basis to comply with the principles but at the same time to suit the particular features of pension provision in the country concerned (or the relevant pension vehicle). Governance would assume a strong role, both at regulatory and at a scheme-speci64257 c level. This would be more consistent with the regulatory approach embedded in the IORP Directive and less divisive. 187 Some commentators would argue that any initial pain, however harsh or uneven, is a necessary price for a more competitive European Community in the long term 171The International Committee of the Pensions Board will be holding a Solvency II pensions open forum at 6pm on 4 March at Staple Inn, at which Chinu Patel will be giving a presentation. Registration is from 5.30pm. Please visit wam.actuaries.org.uk/wam/confbooking.exe to reserve a place.Pensions forumSolvency II is a three-pillar framework setting out the funding and capital requirements, supervisory process and disclosure for insurance companies.Objectives187 A more risk-sensitive approach with incentives for proper risk management187 Consistency between 64257 nancial sectors (insurance v banking) 187 Harmonisation of regulatory standards across the EU, developing in parallel with international accounting standards.Pillar I (capital) requirements 187 Technical provisions equal to the value at risk-free rates of best-estimate cash 64258 ows, plus an explicit risk margin187 Additional solvency capital, set by reference to the company8217s true risk pro64257 le, suf64257 cient to cover technical provisions and other liabilities at the following year-end with 99.5% con64257 dence187 Supervisory action triggered automatically if available solvency capital falls below an objective baseline. What is Solvency II?PensionsRegulation036_037_Actuary_Patel_0308.indd 3719/2/08 15:18:15
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