Pensions World

Pension schemes need to keep an eye on what’s going on over there concerning pension regulation warns Anthony Hilton, Evening Standard

One of the biggest challenges facing the insurance industry is adjusting to the requirements of Solvency II, which is a Europe wide directive which aims to introduce standardised reporting for the industry right across the Union. For the first time, it will be possible to compare the accounts of French, Italian, German and British insurance companies, knowing they have been drawn up on a similar basis, following similar rules and applying similar assumptions.

There is support across the industry for the good intentions behind the proposal but, that said, the nature of the change is so fundamental that the stress and strain of putting it into practice are arousing considerable misgivings.

Significantly tougher

The implications of this for the pensions industry is that, in the eyes of the regulators, pensions and insurance have a great deal in common and Brussels is now giving serious consideration to the drafting of a similar directive for this industry. Crudely speaking, the directive as envisaged would look at the liabilities faced by pension schemes and lay down what it considered to be the levels of capital that each scheme would have to hold to meet those obligations.

Presumably it would not be enough for a scheme to have a solvent and committed plan sponsor. The money would actually have to be in the scheme or pledged in some irrevocable way.

Marked shift

Trustees should, however, also be alert to the other aspect of the approach. The part of Solvency II which will have the most impact is probably not on the liability side where there is a requirement for an internal allocation of capital to match different lines of business. Rather, the real change will come on the asset side and the way in which capital requirements are also going to have to be set for different kinds of investment. The argument again is fairly straightforward. If an insurance company wants to invest its premium income in equities then it will need to be able to show that it has sufficient equity capital to cope with the volatility of equities. The less surplus capital it has, the more it will be required to invest in risk free assets – in essence those which have less volatility – and this will drive it towards short dated government bonds.

Insurance companies make the bulk of their profit from their investment returns. The regulatory push towards risk free assets threatens to make a significant dent in their profitability.

In the pension space the impact of such a philosophical shift would be even more marked. Again, recent times have seen a shift towards bonds as a risk control mechanism designed to offset the dramatic effect on scheme solvency caused by equity fluctuations. But if the insurance approach is imported wholesale it could mean that only schemes with excess capital would be able to invest in equities. This would in effect mean that equity investment would be off limits to all but a handful of schemes.

Considerable opposition

Now there is considerable opposition to the EU proposal and it may never see the light of day so all the above debate may be raising concerns unnecessarily. On the other hand, the reaction to the financial crash from regulators around the world has been for them to put security above performance.

The guiding principle going forward is that no one must lose money, in the belief that that is the most likely way to stop regulators being blamed next time something goes wrong. Nowhere is this more obvious than in the European Union.

This matters because under new rules recently agreed in Brussels, regulatory policy will be made on an EU wide basis meaning that what the Financial Services Authority or its successor bodies do or say will actually be of only limited impact. The domestic bodies will not longer set the regulatory weather. So what happens over there is no longer merely of passing interest. It could easily become the main source of new regulation.

Anthony Hilton is financial editor, Evening Standard; anthony.hilton@standard.co.uk