These are the conclusions of two recent reports on “Solvency II,” a major project commissioned by the European Commission to develop an EU-wide monitoring framework for insurance companies, which may also be applied to retirement funds. The new framework is intended to replace existing national legislation from 2010 onwards.

The main concern for insurance companies is that Solvency II, which advocates risk-based regulation, would limit the scope for equity investment and reduce returns. However, a paper published by Antoon Pelsser et al. argues that it is possible to meet the solvency requirements without a significant impact on the expected return for the insurance companies and their policyholders.*

The paper uses a volatility-switching model to examine the interaction between the insurer and the regulator. It demonstrates that readjustment to a conservative portfolio need only apply for short periods throughout the contract, after which insurance companies will be able to switch to a higher risk asset allocation. For DB pension schemes the outlook is more pessimistic. If the EU were to apply to all retirement funds the solvency rules drafted in mid-2008, this could increase costs significantly for the sponsoring employer, according to a study by risklab.

The quantitative study, which evaluates the impact of risk-based funding requirements on generic DB structures, shows that schemes currently 100% funded under IAS19 will be only 65% funded under Solvency II. It also shows that meeting the funding gap could impose an unacceptable burden on many scheme sponsors. This would force sponsors to consider a range of options, including increased funding, a change in asset allocation, and a move to a risk-sharing structure.

Risk sharing is likely to be the most effective method of bridging the funding gap between IAS19 and Solvency II, the study says. Of the various structures that share risk between the sponsoring employer and scheme members, potentially the most effective – the employer’s right to cut benefits – will also be the most unpalatable for scheme members and labor organizations.

While the risklab study does not comment on the appropriateness of Solvency II for retirement funds, it is to be hoped that it will demonstrate to the EU the unintended consequences of applying rules based on insurance company risks and liabilities to DB schemes.

* On the Cost of Regulation under Solvency II, Life & Pensions, 2008.

Published by PROJECT M in December 2008