Pension Companies
In recent years the situation of life-insurance companies and pension funds has deteriorated in a number of countries. Falling stock prices and low interest rates have made it difficult for the companies to achieve yields that are sufficient to meet the guarantees given. This has drained reserves and increased pressure on the companies' capital. To ensure economic development and financial stability it is important that confidence in life-insurance companies and pension funds is maintained. The influence on financial stability is assessed to be of an indirect nature, e.g. via the financial markets, via group affiliations with banks, and via risk transfer related to the use of financial derivatives.
Danish life-insurance companies and pension funds, jointly referred to as pension companies, are subject to the same regulation under the Act on Insurance Companies. Nonetheless, there are a number of differences between the various types of pension schemes and pension companies, and consequently it is not generally possible to make clear comparisons between pension schemes and between pension companies.
Policyholders have a natural interest in the highest possible degree of transparency, so that they can assess whether the pension company manages and returns satisfactory interest on the pension savings efficiently compared to other pension companies. The pension companies can still do more to improve transparency.
Life-insurance companies and pension funds, jointly referred to as pension companies[1], redistribute and reduce various types of risk for policyholders, and play an important role as managers of long-term savings. Due to the growth in the volume of pension savings, the pension companies exert more and more influence on the financial markets. Chart 45 shows that the pension companies' total balance sheet increased significantly during the 1990s. Pension savings total approx. kr. 1,500 billion[2], equivalent to 110 per cent of GDP.
Different types of pension company
In overall terms, there are three types of pension company: life-insurance companies, labour-market-related life-insurance companies, and pension funds. All pension companies are subject to the Act on Insurance Companies[3].
The pension schemes typically comprise a combination of savings and insurance products. The structure of an individual pension scheme depends on a number of different factors. Labour-market pension schemes are compulsory, while individual pension schemes are taken out on a voluntary basis. Most pension schemes, i.e. both labour-market and individual pension schemes, are based on a guaranteed interest rate, cf. Box 7. Among other things, this means that the pension company is subject to an obligation to pay a fixed minimum nominal yield throughout the lifetime of the scheme.
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Box 7
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When a pension scheme is established, the premium payable by the policyholder is agreed, and the relationship between the premiums paid and the pension and insurance benefits receivable by the policyholder via the pension scheme are calculated. This calculation is based on a number of assumptions of the risk of disability, mortality, and interest rates and costs. The maximum technical interest rate is used to calculate pension and insurance benefits to policyholders. The maximum technical interest rate is identical to the guaranteed rate of interest. The assumptions as to risk of disability, mortality, interest rates and costs must be based on conservative estimates, since the guarantees may be of long duration. The use of conservative estimates on calculating pension and insurance benefits normally results in profits. These profits may derive from insurance elements, investment returns and costs. A proportion of this profit is distributed to policyholders as bonus. The return accruing to the pension scheme each year is known as the deposit interest rate. The deposit interest rate is usually based on an average-return principle, which means that all policyholders in a pension company obtain the same deposit interest rate, irrespective of whether they have individual schemes or labour-market pension schemes, and that the deposit interest rate is determined on the basis of the pension company's bonus policy and the development in the investment yield over several years. The deposit interest rate is thus in principle independent of the investment return in the individual year. The average-return principle means that it is sought to smooth the yield over time, thereby supporting stable and predictable development in pension and insurance benefits. In addition, the smoothing of the yield means that redistribution takes place between groups of policyholders. In connection with the presentation of pension companies' accounts the present value of the life-insurance provisions is calculated on the basis of a discount rate. The pension companies may also make present-value calculations based on a zero-coupon-yield structure estimated by the pension company. |
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Traditional life-insurance companies are limited-liability companies offering both labour-market and individual pension schemes. Limited-liability companies established specifically for this purpose, known as labour-market-related life-insurance companies, may also write labour-market pension schemes. A labour-market-related life-insurance company is directly or indirectly owned by the policyholders' trade union or professional organisation, possibly jointly with the employers' organisations for the relevant industries, and is established as a result of a collective agreement. Labour-market-related life-insurance companies do not pay out dividend to their owners. Pension funds may, like life-insurance companies, establish both labour-market and individual pension schemes. Pension funds are associations or societies owned by their members who share the same educational background or are employed within the same sector.
The ownership structure of the various types of pension company determines who in actual terms must fulfil the guarantees given. If the realised result does not cover the guarantees, the reserves and equity capital may be drawn on. If a pension company finds itself in a situation where the reserves have been exhausted, the equity capital must be used to fulfil the guarantees. If the equity capital is not sufficient to meet the guarantee commitments, the owners of a life-insurance company may have an interest in contributing further capital to the company, e.g. to maintain its reputation. It is less certain how the owners of a pension fund will react in this situation, since the members themselves have issued the guarantees via the collective agreements established with the relevant labour-market bodies.
Distribution of profits in the pension companies
The different ownership structures influence the distribution of profits in the pension companies. Most pension schemes are subject to a bonus entitlement. The calculation of the guaranteed pension and insurance benefits is based on prudent assumptions, so that normally a return is available for distribution between the owners and the policyholders.
The contribution principle guides the distribution of the realised result between owners and policyholders and mutually among policyholders. The distribution is based on how much the owners and policyholders have contributed to achieving the result. The contribution principle is applied in the same way to the distribution of losses between owners and policyholders. As a consequence of the contribution principle, the return on the equity capital is not necessarily dependent on the result for the year and thereby calculated on a residual basis, as is the case in all other types of companies.
In life-insurance companies the owners and policyholders may have diverging interests regarding the distribution of profits. On the one hand, the owners may be interested in carrying the profit to equity capital, while on the other hand the policyholders may prefer distribution to policyholders. In this respect the members of pension funds are both policyholders and owners.
The pension companies must set up rules for the return on equity. A review of a number of these policies for equity returns shows that the return on equity in a pension company generally comprises two elements. Firstly, a return that is in line with the yield paid to policyholders, and secondly a risk premium that must be reasonable in relation to the risk associated with providing equity capital. The risk premium in pension funds is calculated mainly as a percentage premium on the yield or deposit rate payable to policyholders. In most life-insurance companies the risk premium is a percentage of a balance-sheet item, e.g. life-insurance provisions. The risk premium is thus not directly related to the current yield achieved by the life-insurance company. This difference in the calculation of the risk premium means that the return on equity in life-insurance companies will be more stable than the return on equity in the pension funds.
The development in the two key indicators, bonus reserves[4] and equity reserves[5], may give an indication of the differences in how life-insurance companies and pension funds build up their buffer capital. Chart 46 illustrates that in the life-insurance companies the equity reserves show stable development, while the bonus reserves fluctuate considerably. This indicates that the life-insurance companies primarily use the bonus reserves as buffer capital. In the pension funds, the bonus reserves have been reduced to a low level in recent years, while the level of equity reserves has fluctuated. Pension funds primarily use the equity reserves as buffer capital.
Pension companies' risks, framework and transparency
In recent years there has been some focus on policyholders' influence on the structure of pension schemes, and opportunities to make individual choices. A number of pension companies have given policyholders more influence on the investment structure, but this is still the exception. For example, there is a high degree of interdependence between the individual policyholders in a compulsory labour-market pension scheme. This is not immediately compatible with full freedom of choice, since the options may have consequences for the other policyholders under the scheme.
It can be rather difficult to gain an overview of pension schemes. This is one reason that an Information Order has been issued. The order makes it compulsory for pension companies to provide policyholders with adequate information on their rights and obligations. The Information Order relates to the individual pension agreement, but not to the general framework under which the pension companies must operate.
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Box 8
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The assets of a pension company primarily comprise properties, shares and bonds. These assets involve market and credit risks. Pension companies' investments covering commitments to policyholders are subject to investment rules which lay down quantitative limits to investments in the various types of assets. In addition, congruence rules have been laid down to set limits to the mismatch between the currency denominations of the assets and liabilities. In connection with the introduction of the flexible share ceiling in 2001 two risk scenarios were set up which are used to illustrate whether the relationship between the investment risk and capital provides adequate security that the pension companies at any time will be able to fulfil their commitments to policyholders, cf. Box 9. The pension companies' risks in terms of liabilities partly comprise the risk that the insurance assumptions of disability and mortality do not accord with the actual disability rates and mortality among policyholders. For instance, extra provisions must be made for old-age pensions if the life expectancy of policyholders is longer than first assumed. To this should be added the interest-rate risk arising when the pension companies guarantee a fixed nominal interest rate to policyholders many years into the future. The long-term nature of these guarantees entails that the valuation of the life-insurance provisions will be sensitive to changes in the level of interest rates. |
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Guaranteed interest rate and interest-rate risk
In connection with the determination of the common tariff in 1982, the maximum guaranteed rate of interest after tax (the maximum technical interest rate), which the pension companies may apply to calculating pension and insurance benefits, was agreed at 4.5 per cent.[6] Until mid-1994 the pension companies applied a maximum technical interest rate of 4.5 per cent. It was then lowered by the Danish Financial Supervisory Authority to 2.5 per cent. In 1999 the maximum technical interest rate was reduced further to 1.5 per cent. The maximum technical interest rate applies throughout the lifetime of the pension scheme, so that the agreements established up to mid-1994 still yield a guaranteed rate of interest of 4.5 per cent. These are maximum guaranteed rates of interest, and the pension companies have been at liberty to create pension schemes based on lower guaranteed rates of interest, or without any guarantees at all. Chart 47 illustrates the development in the maximum technical interest rates compared to the average yield to maturity on a 10-year government bond after the tax on pension returns.
As the Chart shows, the yield to maturity on 10-year government bonds, which illustrates the risk-free yield, has not been sufficient to cover the pension companies' guarantees of 4.5 per cent during much of the period since 1988[7]. The falling level of interest rates during this period has furthermore enhanced the need for further provisions for commitments. Together with the development in the stock markets in recent years this has made it necessary for the pension companies to draw on their reserves and equity capital.
The reduction of the maximum technical interest rate has entailed that many pension companies have pension schemes with different guaranteed rates of interest. Differences in the guaranteed rates of interest may lead to conflicts of interest between the different groups of policyholders. Those with low guaranteed interest rates may in principle engage in investments at a higher risk than policyholders with high guaranteed interest rates.[8] In a situation where market yields are relatively low, the high guarantees will stimulate investment in bonds rather than shares which are subject to a greater risk, in order to ensure that the guarantee obligations are still met.
It is estimated that around 2/3 of the pension companies' commitments are based on the high maximum technical interest rate of 4.5 per cent. The volume in pension schemes based on guarantees of 4.5 per cent is still increasing as a result of the accrual of interest and current payments. The level of interest rates was considerably higher in the early 1980s than is the case today. The guaranteed rate of interest was far below the level of interest rates and thus probably functioned more as a basis for calculation to illustrate the development in policyholders' savings, and in connection with the pension companies' internal distribution. However, the development in the level of interest rates and in tax rules has made fulfilling the guarantees a greater challenge to the pension companies. So providing guarantees so far into the future is not unproblematic.
The increased focus on the risks to the pension companies, as well as the market development since 2000, have led the pension companies to launch a number of initiatives to hedge their risks. On the asset side, stock portfolios have been reduced in order to limit losses from further price drops and create greater symmetry between assets and liabilities. However, the pension companies' commitments are more sensitive to falling interest rates than bonds. Capital gains on the bonds therefore cannot cover the increased need for provisions for commitments. The interest-rate risk thus cannot be hedged solely by investing in bonds, due to the duration mismatch.
In recent years many pension companies have hedged all or part of the interest-rate risk via financial derivatives. Information on the use of financial derivatives varies greatly in the accounts presented, so that there is no clear picture of its scale. It would be natural to present clear and transparent information in financial statements on the scale of hedging via financial derivatives. Several pension companies also use financial derivatives to hedge other types of risk, e.g. the risk of falling stock prices and exchange-rate fluctuations.
Some pension companies have considered dividing their insurance portfolios into policy blocks based on the size of the guarantees provided. This would make it possible to draw up an investment policy for each policy block that matched the guarantees given.
Moreover, several pension companies have introduced conditional crediting of the interest, which may be revoked if inter alia the return on investment falls short of expectations. On the one hand, conditional crediting of interest can help to ensure appropriate distribution between generations. On the other hand, the use of conditional crediting makes it difficult for policyholders to comprehend what has actually been credited.
The aforementioned initiatives will help the pension companies to fulfil the guarantee commitments. The risk in relation to the guarantees provided can hereby be minimised, but in general the pension companies have only limited opportunities to amend the terms of existing pension schemes.
For new pension schemes, however, there is greater scope for development, and several pension companies have already introduced new pension products such as pension schemes based on zero interest guarantees or unit-link schemes. Overall, the new schemes are deemed to give the pension companies greater room for manoeuvre.
Accounts at market value and key ratios
As from 1 January 2002 the pension companies could present their accounts on the basis of market values. Since 1 January 2003 this has been compulsory. During 2002 a number of pension companies took advantage of this opportunity, and the first annual accounts based on market values were published in the spring of 2003. The key items of the balance sheets of the pension companies are presented in simplified form in Table 4.
On the asset side the new rules entail that, in future, bonds must be stated at market value. Valuation of bonds at market value does not entail problems. Other types of assets, e.g. land and buildings and stocks, have already been stated at market value.
Similarly, the liabilities, including insurance provisions, must be measured at market value. An innovation is that life-insurance provisions are now split into three sub-items: guaranteed benefits, bonus potential related to future premiums, and bonus potential related to benefits on premium-free policies. Guaranteed benefits comprise the commitments to fulfil payments guaranteed to policyholders. The bonus potential related to future premiums relates to the future premiums, and the bonus potential related to benefits on premium-free policies relates to premiums which have already been paid up. In simplified terms, the relation between the three sub-items under life-insurance provisions can be described as follows: if the discount rate is equal to the guaranteed rate of interest, the bonus potentials will equal zero, and the guaranteed benefits will equal the life-insurance provisions. If the discount rate is greater than the guaranteed rate of interest, there will be bonus potentials as a bonus potential related to future premiums and/or a bonus potential related to benefits on premium-free policies. The distribution between bonus potential related to future premiums and bonus potential related to benefits on premium-free policies depends on when the pension scheme was established, among other things.
The bonus potential related to benefits on premium-free policies is now included as an element in the pension companies' reserves and may be used to offset losses on assets, should the collective bonus potential be insufficient to cover the policyholders' share of any losses. The value of the guaranteed benefits will be affected by ongoing fluctuations in interest rates. If interest rates drop, the value of the guaranteed benefits will increase, and the bonus potential related to benefits on premium-free policies – and thereby the ability to withstand losses on assets – will decline, and vice versa if interest rates increase.
Collective bonus potential is the policyholders' collective undistributed reserves against fluctuations in the value of the assets and negative development in insurance risks and costs. If the collective bonus potential exceeds what is deemed necessary as a provision against unfavourable developments, distribution must take place to policyholders on an individual basis.
Pension companies' accounts at market value reflect a more true and fair picture of the economic risks faced by pension companies. Furthermore, the breakdown of the life-insurance provisions provides a clearer picture of the pension company's risk profile than previously. For instance, a pension scheme with a low guaranteed rate of interest will have a larger bonus potential related to benefits on premium-free policies than an equivalent pension scheme with a higher guaranteed rate of interest. The market value statement will disclose the difference between the risk profiles of the two pension schemes. Against this background, accounts based on market values are more transparent than the previously presented accounts. The introduction of the bonus potential related to benefits on premium-free policies has also meant that many pension companies have gained extra reserves against losses, created via the technical breakdown of life-insurance provisions, and thus not by increasing the capital base. The extra reserves will mean that a pension company will experience problems later rather than sooner, but the reserves do not remove the underlying risks. On the other hand, there is no doubt that accounts based on market values will show greater fluctuations, which will increase the demands on reserves and capital in the pension companies.
As stated above, the return on equity is not necessarily residually determined, as is the case for all other types of company. If the return on equity is not at the level determined in the pension company's profit policy, owing to a shortfall in realised results, the required return on the equity capital may be booked to a "shadow account". The shadow account expresses the equity capital's claim on the future positive realised results that exceed the prescribed return stated in the pension company's profit policy. The shadow account is not stated in the pension companies' balance sheet, although the size of the amount expected to be allocated to the equity capital at a later date must be stated. Most pension companies operate with shadow accounts. The use of shadow accounts means that the return on equity over several years is not affected by low realised results in single years. The shadow account will thereby contribute to smoothing the effects of market fluctuations, irrespective of the chosen profit policy. On the other hand, the use of shadow accounts reduces the transparency of the pension companies' annual accounts, since the equity-capital requirements are not stated in the balance sheet.
In addition to the accounts, the pension companies publish a number of key ratios that are calculated on a standardised basis. The key ratios were introduced in 1995 and have helped to give policyholders a better insight into yields, costs and consolidation issues in the pension companies. In connection with the transition to market values, only minor adjustments were made to the key ratios, but a committee is currently working on an actual revision of the key-ratio system for pension companies, including setting up key ratios for the return on equity and accrued returns to policyholders. It is believed that new key ratios will increase transparency and the basis for comparisons between pension companies.
Risk scenarios
In 2001 the flexible share ceiling took effect. This means that the pension companies may place up to 70 per cent of the assets covering their commitments to policyholders in shares and non-gilt-edged assets. In connection with the introduction of the flexible share ceiling it was made clear that the pension companies must ensure that their investments do not jeopardise their commitments to policyholders at any time. When assessing the investment risks of pension companies in relation to capital and commitments to policyholders, two simple risk scenarios are applied, popularly known as the amber and red lights, cf. Box 9, which also includes a tentative calculation of the effect of the risk scenarios.
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Box 9 |
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Risk scenarios The amber scenario assumes a change in interest rates by 1 percentage point in the direction entailing the highest losses; a fall in share prices by 30 per cent; a fall in property prices by 12 per cent; and losses in connection with credit, counterparty and exchange-rate risks. The red scenario assumes a change in interest rates by 0.7 percentage point in the direction entailing the highest losses; a fall in share prices by 12 per cent; a fall in property prices by 8 per cent; and losses in connection with credit, counterparty and exchange-rate risks. It is sought to calculate the effects of the individual risk factors in the risk scenarios for the pension companies which have presented their accounts, in order to indicate how the robustness of the pension companies in general developed from 2001 to 2002. It should be noted that the calculation does not take account of the pension companies' hedging of risks via financial derivatives, since the extent of hedging is not stated on a uniform basis in the accounts. Most pension companies use financial derivatives to hedge risks. The assumptions entail that the risk scenarios will not generally affect the pension companies as severely as the calculation shows, provided that the market develops as assumed. Due to the assumptions, no clear and unambiguous conclusions can be drawn, but it is estimated that the calculations give an indication of development trends in capital and risks of the pension companies. According to the calculations, the pension companies overall were unable to handle the amber risk scenario at the end of 2001, since the overall risk in the amber scenario exceeded the total financial buffer. At end-2002 the calculations show that the pension companies were able to handle both the amber and the red risk scenario. A key reason for the pension companies appearing more robust at end-2002 is that they have acquired an extra buffer, i.e. bonus potential related to benefits on premium-free policies. The Table also illustrates that the pension companies' reduction of their share portfolios has significantly lowered the risk of losses as a result of falling share prices. In addition it can be seen that the collective bonus potential was virtually halved between 2001 and 2002, which affects the future potential for bonus. |
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| Calculated effects of the amber and red risk scenarios and the overall financial buffer, end-2001 and end-2002 | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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calculation assumptions The calculations of the effects on respectively the amber and red risk scenarios are based on the following assumptions:
The exchange-rate risk is assumed to be distributed at 75 per cent and 25 per cent of holdings in foreign currencies in EUR and USD respectively. |
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The use of risk scenarios has enhanced the Danish Financial Supervisory Authority's opportunities to monitor a pension company and intervene at an earlier stage, before any problems develop into an actual solvency crisis. There is no requirement for the pension companies to publish the effects of the red and amber risk scenarios. A few pension companies have, however, begun to publish this information on a regular basis, and it is believed that precisely this type of risk information can help to increase transparency and thereby give policyholders a better insight into the robustness of the pension companies.
[1] In connection with the discussion of accounting items the terminology applying to life-insurance companies is applied generically to the pension companies.
[2] Pension Market Council report, April 2002.
[3] Other pension providers, e.g. The Danish Labour Market Supplementary Pension Scheme (ATP) and LD Pensions, and company pension funds are subject to separate acts.
[4] The bonus reserves are the undistributed reserves as a ratio of life-insurance provisions.
[5] The equity reserves are the excess equity capital as a ratio of life-insurance provisions.
[6] See Charlotte Møller, Tilsynet med risikostyring i livsforsikringsselskaber og pensionskasser, (Supervision of risk management in life-insurance companies and pension funds – in Danish), Finans/Invest 8/01.
[7] The actual yield to maturity after tax has been higher in the pension companies, e.g. due to the transitional deduction introduced in connection with the real-interest-rate tax.
[8] Under the contribution principle, systematic redistribution involving considerable amounts must not take place between insurance policies, cf. the Order on the contribution principle of 30 January 2003.