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"Financial stability 2002"

Issues related to financial stability

Pension Companies and Financial Stability

Pension companies play an important role in the financial sector, by smoothing out risks among pension savers and as managers of long-term savings. In terms of economic development, confidence in pension companies as managers of long-term savings is important. When compared with banks, the effect of pension companies on financial stability is, however, assessed to be more indirect. For instance, financial stability may be influenced via the financial markets, via group ties with banks, or via other types of risk transfer between banks and pension companies.

Central functions of banks and pension companies

Banks and pension companies^[1] play a central role in the financial sector. Their fundamental functions are different, so they have different impacts on financial stability. However, both contribute to redistributing and minimising various types of risks for customers.

In recent years, the trend has been towards increased integration between banks and pension companies, e.g. in the form of financial conglomerates and via markets for risk transfer. This may entail both strengths and weaknesses in terms of financial stability.

Banks' fundamental tasks are to receive deposits from and grant loans to the public, as well as to be an important link in payment systems. In principle, the borrower and lender could meet directly in the market without an intermediary, but banks have accumulated considerable credit-assessment competencies. Using the bank as a link makes it cheaper for the two parties to meet.

The banks' expertise in credit granting limits the credit costs so that resources in the economy can be put to better use. In addition, banks play an important role in payment systems. In other words banks carry out a number of functions which are important to the economy.

The mismatch on the banks' balance sheets between non-liquid assets (loans not readily negotiable in a market typically constitute a large share of the assets) and liquid liabilities (e.g. deposits, loans from other banks or issue of short-term papers) poses a liquidity risk for the banks, cf. Box 2. Insufficient liquidity-risk management or loss of confidence in the bank may lead to vulnerability in connection with sudden realisation of claims by depositors or other financial institutions (e.g. in the form of funding problems in the interbank market). Problems in one bank may spread to other banks, e.g. via interbank accounts or payment systems. Extensive problems in the banking system may affect growth and employment as a result of lower loan activity, among other factors.

Box 8 Various types of pension systems

Pension companies play an important role in the financial sector, by smoothing out risks among pension savers and as managers of long-term savings.

Pension-company products are mostly a combination of savings and insurance. Danish pension benefits are typically subject to a guarantee, cf. Box 8. Savings in pension companies are characterised by a group of policy-holders pooling their funds on a solidarity basis in terms of various risk types. The financial consequences of insurance risks are equalised by the group, and redistribution takes place among the policy-holders. Furthermore, the return on investment is smoothed out over the years so that the value of the pension only to a limited degree depends on the current market situation. As asset managers of their clients' savings the pension companies also have a better opportunity to diversify investments than the individual savers. In other words, a pension company offers the individual client greater diversification and lower transaction costs, e.g. in connection with investment in securities, while evening out the return over time.

Fundamentally, a pension scheme is based on a solidarity principle. That is why pension companies charge a fee (surrender charge) when a client transfers to another company^[2]. Pension companies lay down their own rules for such charges, which may consist of several elements, e.g. the costs relating to administration of the surrender transaction (transaction costs for settling the insurance) and still unpaid costs which relate to the policy-holder. Such costs are not charged as one-off fees when the insurance policy is taken out, but distributed over the entire term of the insurance. This part of the surrender charge therefore ensures that the client's costs are paid by the client. The surrender charge may also cover a special fee related to market prices to avoid speculation in transfer of the policy. This fee may be charged where the market value of the assets is lower than the book value and can be justified as a means of protecting remaining clients and the pension company's equity.

It is still uncertain whether this fee can be justified after the introduction of the market-value principle for valuation of pension-company assets as from 1 January 2002.

Transfer charges impede pension clients' mobility, which reduces the possibility of direct competition on pension schemes in the same way as e.g. banks compete on deposit terms. The "market discipline" options (dissatisfied clients transferring to another company) are not as extensive as in the banking sector. A higher degree of comparability and transparency in terms of pension companies' results and risk sensitivity would enhance market discipline.

The lower degree of market regulation of pension companies is the reason why these companies' profit distribution – between pension clients and owners, and among pension clients themselves – is regulated by the authorities to prevent unintended redistribution.

The authorities regulate the distribution of pension-company profits on the basis of the "contribution principle", i.e. the profits are distributed among the individual pension savers and the owners on the basis of their contribution to generating the profits. The proportion attributable to pension savers (bonus) must be released in a fair manner during the term of the insurance agreement. Under the contribution principle it is emphasised that major, systematic redistribution must not take place between different client age groups.

Pension companies are not as vulnerable to liquidity risks as banks, partly because their liabilities are more long-term, and partly because the part of their investments relating to obligations vis-à-vis clients is typically more liquid than bank assets and are moreover subject to special investment rules. In addition, pension companies have collective reserves, which are part of previous years' profits which have not yet been distribution to clients.

While collective reserves are positive, the vulnerability of the pension company, viewed in isolation, will not increase if a client leaves the company. In connection with the transfer the pro-rata share of the collective reserves cannot be claimed, i.e. the collective reserves remain unchanged in connection with a client's transfer, whereas the company's obligations and corresponding assets are reduced. As stated above, the companies have found it necessary in some cases to introduce a special market price related fee. Finally, pension companies do not involve a systemic risk to financial stability. This may be the case when a bank has a liquidity crisis, since there are often counterparty risks between banks, e.g. in connection with money-market transactions.

Overall, pension companies are not deemed to have the same direct influence on financial stability as banks. The main risk relates to the size of the clients' future pensions. In case of problems within a pension company, the losses suffered by savers will be limited by the market value of the securities portfolio supporting the commitments to clients. In terms of economic growth it is, however, important that pension companies are trusted as savings managers, so that pension savers have confidence in this type of savings.

Pension companies' indirect effect on financial stability

In comparison with banks, pension companies are deemed to have a more indirect effect on financial stability. Problems in pension companies may affect financial stability via the financial markets, via group ties with banks or via other types of risk transfer between banks and pension companies.

Financial-market effects

As significant savings managers, pension companies may have a major influence on the financial markets. In recent years, Danish pension companies have increased their holdings of – primarily foreign – shares, e.g. as a result of the liberalisation of the investment rules^[3]. Up to 2001 growth in the holdings of foreign shares was to the detriment of bonds, since the bond ratio fell from just over 80 per cent in the early 1990s to just under 60 per cent in 2000, cf. Charts 40 and 41. Presumably the increased focus on shares has been based on a policy of diversification and higher returns. Preliminary figures indicate that the bond ratio increased in 2001, which should be interpreted in the light of market trends in the autumn of 2001 and subsequent portfolio adjustments.

When interest rates and/or share prices decrease, pension schemes with extensive guarantees will increasingly limit the pension companies' choice of investment policy. This was the case in the autumn of 2001, when the plummeting share prices after 11 September accentuated the problems in the pensions sector^[4]. The companies mainly sold foreign shares, cf. Chart 41. Liquidity in foreign shares is deeper than in the Danish share market, so large amounts can relatively quickly be traded without significant price effects. A similar reduction in the holdings of Danish shares would presumably have to be effected over a far longer period in order to avoid a squeeze on the market.

In 2001 a number of Danish pension companies used financial instruments to hedge further loss-generating drops in bond yields and thus avoid inexpedient restructuring, cf. the chapter on trends in the financial markets.

Effects via financial conglomerates

The links between banks and pension companies are becoming closer and closer. This is e.g. reflected in the establishment of financial conglomerates comprising both banking and life-insurance business. In addition to ordinary, business-specific risks, financial enterprises forming part of a financial conglomerate are exposed to special risks as a result of the conglomerate structure. For instance, the formation of a conglomerate may pose a risk to a bank which finds it necessary, for reputational reasons, to support an ailing company within the group. Problems within one company in the conglomerate may thus have an effect on the bank, even though the bank basically does not have any problems^[5]. This can also impact financial stability.

Risk transfer between banks and insurance companies

Apart from the formation of conglomerates, the links between banks and pension companies have been strengthened in a number of other areas. The international financial markets have seen a boom in new products and markets for risk transfer, including credit, market and insurance risk, via derivatives and securitisation. The typical picture for risk transfer between banks and pension companies is that banks transfer their credit risks to pension companies, while the latter have increasingly begun to use the financial markets to hedge market risks (for instance, Danish pension companies have used the options markets to hedge interest-rate guarantees granted to pension clients). Transfer of insurance risks to non-insurance companies is very limited^[6].

In relation to financial stability this type of risk transfer offers advantages, e.g. by rendering the financial institutions less vulnerable to regional, sectoral or market shocks, etc. Spreading the risk on several participants may also be an advantage. Diversification gains can thus be achieved through risk transfer. This can help to give clients lower product costs, which again benefits the economy as a whole.

On the other hand, risk transfer can also involve a number of drawbacks. Increased interdependence among the different financial institutions makes it more difficult for the authorities to monitor total risk in the financial sector and the risk distribution among the various institutions. If financial stability is purely assessed on the basis of the banks' situation, a spread in credit risk has a stabilising effect. It should be emphasised that the use of credit derivatives does not entail complete transfer of credit risk, since it is replaced by a counterparty risk. This means that in periods of recession or financial unrest, where the counterparty may also become financially vulnerable, there is a risk that the counterparty cannot meet its obligations. In principle the credit risk might thus revert to the bank ^[7].

Pension companies may play a more central role in connection with greater spread of credit risk away from banks. In relation to financial stability it would be important for other financial institutions also to have the necessary knowledge and capacity to assess the consequences of this risk[8]. Finally, it should be underlined that such credit-risk transfer is mainly an international trend.

Problems in relation to the interest-rate guarantee system

Pension companies' risk profile differs from that of banks. On the assets side, pension companies have investment risks in the form of market risks and risks of fluctuations in real-property prices. Pension companies' liabilities are associated with insurance risks and an interest-rate risk[9]. Calculation of the relationship between the premiums paid and the benefits offered to the insured under the insurance policy is based on a maximum technical rate of interest. A large part of the Danish insurance agreements are based on an interest rate of 4.5 per cent, which was the maximum technical rate of interest from 1982 to 1994. This rate seemed low at the time of introduction and was presumably seen as a calculation assumption, but it has subsequently caused problems due to the low interest-rate level in recent years. Pension companies therefore face a considerable risk in that clients have been guaranteed a minimum nominal interest rate, which must be met for many years ahead.

Most Danish pension schemes are defined-contribution schemes, cf. Box 8, but in relation to pure defined-contribution schemes the risk on return to the client is limited, in that the pension company has typically issued an interest-rate guarantee. In other words, pension companies are bound in several ways. On the one hand they have guaranteed a certain interest rate, on the other hand they cannot claim higher contributions from the savers.

The long-term nominal interest-rate guarantees and the minimum solvency requirements^[10] for pension companies are the two determining factors behind Danish pension companies' investment policy. Interest-rate guarantees may thus involve a kind of cost in the form of less freedom to compose the asset portfolio and can thus lower the yield potential for investment assets.

The drop in share prices and long-term interest rates in the autumn of 2001 exacerbated the guarantee problems experienced by a number of pension companies which found it difficult to meet the statutory capital requirements. Some companies have hedged against decreases in interest rates via the options market. Some pension companies are also considering splitting up policy blocks, by the size of the guarantees, in various sub-blocks with related investment assets. For each sub-block an investment policy may then be pursued which best matches the individual guarantees. The higher the maximum technical rate of interest, the more cautious the investment policy. Thus customers with extensive guarantees basically finance these guarantees themselves.

Up till now, many insurance companies have fixed the deposit rate for clients one year ahead, and this rate has been an important competitive parameter among pension companies. On the basis of the problems experienced by the sector in the autumn of 2001, many companies have now adopted a new approach in respect of deposit rates. Generally, the 2002 level is lower than the 2001 level, and in addition some companies have introduced a variable rate over the year, depending on the development in the return on investments. Flexible deposit rates can make it easier for companies to meet their obligations. On the other hand, different methods for fixing deposit rates reduce transparency for clients^[11].

In general, the scope for changing the terms of guarantees already given is presumably limited. For new contracts, however, there is room for development. Considering that most pension schemes are established with very long-time horizons, it would be expedient for the pension system to be adjustable and better geared to tackle changes in the economic assumptions.

Footnotes

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Version 1.0 Maj 2002 Nationalbanken.
Published by Danmarks Nationalbank Maj 2002, http://www.nationalbanken.dk/