Pensions World

Lindsay Tomlinson, NAPF chairman, explains why UK schemes should start to worry about the impending arrival of Solvency II

If you are running a UK pension scheme, should you worry about Solvency II? The answer depends on your time horizon: short term, maybe; medium term, probably; long term definitely.

It is the largest ever change to European insurance solvency regulations. Those involved in pensions may smile when they hear that it is based on three pillars. Pillar 1 sets out capital requirements, Pillar 2 covers governance and Pillar 3 concentrates on disclosures and transparency. It is not just about capital. It is a root and branch review of the way insurance business is conducted in the EU. The European Commission estimates its cost at €2–3bn over five years, uncannily similar to the original budget for the 2012 Olympics. Expect a similar outcome.

Key features relating to capital requirements are the use of market consistent bases to quantify assets and liabilities, a value at risk approach to setting the Solvency Capital Requirement and the ability for individual firms to use their own internal models in the process.
The project is now in full implementation mode and is due to be in force in January 2013. At this stage, key compromises are made. The aptly named Omnibus 2 Directive is before the European Parliament and we await the final big decisions.

Supporting assets

For me, the absolute key issue is the application of market consistent valuation bases to long term insurance business. The concern in the case of Solvency II is twofold. Firstly, because equities have more short term market volatility than bonds, a market consistent basis results in more capital being required to support equity investment. This is a bad idea in itself. Secondly, using short term market volatility to evaluate capital required for long term business results in capital requirements which are too high. We need to enable assets supporting long term business to ride long term cycles. Failing to do this means that all long term products will become unnecessarily expensive.

The good news is that when it comes to Solvency II, this is understood. Current discussions focus on adding an “illiquidity premium” to discount rates to reflect the long term nature of the liabilities. Let us hope this fix works. Right now, we can only watch this space.

How relevant is this to UK pension schemes?

EU pension schemes are covered by the Institutions for Occupational Retirement Provision Directive and are out of scope for Solvency II. After discussion, it has been agreed that there will be no direct read across of Solvency II to this Directive. Nothing to worry about short term, then. But the overwhelming majority of EU member states do not have UK style schemes. The EU legislative process is in flight and we know significant late stage politically inspired changes can happen. That is the short term worry.

Aside from the direct application of Solvency  II to pension schemes, we need to remember that pensions and insurance are inextricably interlinked. As Solvency II currently stands, capital requirements for long term insurance products such as annuities and pension buyouts are going up. Their costs are therefore going to increase with a direct and substantial impact on pension schemes. That is the medium term worry.

Finally, in the EU, finance splits into banking and insurance. There is no middle ground. Pensions sit firmly in the insurance bucket. The same regulatory philosophy and supervisory authority underpins insurance and pension provision. If regulations are good for insurance, they will be considered good for pensions. That is the long term worry.

Solvency II is coming and it is right for UK pension schemes to worry about it.