The tumbling equity markets have placed Denmark’s pension funds and insurance companies on the horns of dilemma. To improve their solvency they have been compelled to carry out a fire sale of equities. But without equities they know they cannot hope to rebuild their depleted reserves.
The dilemma is a consequence of a change last year to the system of supervising Danish pension funds. Henrik Bjerre-Nielsen, the director general of the Danish Financial Supervisory Authority (DFSA), explained the reason for the change earlier this year in a KPMG-European Commission conference: “Because of the long term obligations with a guaranteed interest rate , the interest rate risk is very high in the Danish life insurance industry. The required solvency margin does not take into account investment risks - including interest rate risk.”
So, following a change in the Insurance Business Act, which relaxed the rules governing insurance firms’ investment, the DFSA introduced two stress tests to assess the financial strength of the life insurers.
The two stress tests are the red light scenario and the yellow scenario. The red scenario requires the life insurers to have the same financial strength as a bank that has assumed the same investment risks – but never less than the required solvency margin.
In numerical terms, this means that insurance companies must be able to make up their total potential loss in the event of a simultaneous 12% fall
in share prices and a 0.7 percentage point change in the interest rate level.
“The red scenario implies that if a firm’s capital drops below the required financial strength the policy- holders’ interests may be in danger and the firm is required to immediately report the situation to the DFSA,” says Bjerre-Nielsen. “ The DFSA will then assess the specific situation and if the policy holders’ interests are deemed in danger it may order the firm to decrease its risk profile.”
The yellow scenario requires the life insurers to calculate the effect on their financial strength under more extreme circumstances. Here the loss is made up on the assumption that equities fall by 30% and that the interest rate changes by 1% point.
If an insurance company or pension fund does not have the financial strength to absorb these falls, the DFSA will assume that the interests of the company’s policyholders are potentially in danger. Supervision is tightened and the firm is required to report the calculations to it every quarter.
“Turning on the yellow light may hence be seen as a warning to the firm concerned of a high risk profile,” says Bjerre-Nielsen.
The system has been picked up eagerly by the Danish press. In July, the national daily Berlingske Tidende carried out a straw poll of insurers and pension funds and found that Industriens Pension, DIP, Juristernes & Økonomernes Pensionskasse, Fin-anssektorens Pensionskasse and Skandia Liv had all triggered yellow lights.
However, the pension insurers and their consultants have complained that the focus on the yellow light scenario is forcing pension funds to sell their equity holdings – the seed corn of their portfolios. Hasse Nilsson, chairman of Alcifor Advisory Associates in Copenhagen says the inflexibility of the authorities is costing the companies and the country dear,
“Last year, following September 11, the pension fund reserves came down from between 30% to 40% to 15% to 20% and the authorities were highly inflexible in terms of giving way in some of the stringent reserve requirements. This had a detrimental effect because most of the institutions were forced to dispose of their equity holdings. In macroeconomic terms, this is extremely silly, because you always end up selling at the bottom of the market.
“Today we have a double dip situation where even more institutions are forced to reduce their equity holdings. It is ridiculous when you think of the status of Danish reserves compared with the status of fund reserves across Europe which are suffering much more deeply.”
Nilsson places the blame squarely on the inflexibility of the DFSA. “One could think there are many ways of lifting these hard restrictions, at least temporarily, but the authorities have not been willing to do that,” he says.
The worst restriction, he says, is the obligation to calculate their risk every day against movements in the market. “They are required to calculate on a dally basis a sort of moving average of the discount rate that is used by institutions in assessing their liabilities. The discount rate has been lowered alongside the general fall in interest rates. That has had a tremendous effect on the reserve status as well. But it doesn’t reflect the sort of long term relationship that exists in the market. That sort of calculation is highly questionable and tends to underestimate the reserves of the individual institutions over the longer horizon.”
“These daily calculations are also extremely time-consuming for the institutions. When pension funds and insurers should have been actively occupied in day-to-day business, they are now occupied looking at the reserves status every single day,” he says.
Holger Dock, the director of administration at AP Pension and the chairman of Forsikring & Pension, the Danish Insurance and Pension Funds Association, is leading the campaign to have this obligation removed.
“It is not fair that short term changes in the stock rate should be able to totally rule the long term savings and the long term dispositions for the insurance company and for the pension fund,” he says.
“We also think that the day-to-day changes of the stock market is not a real value change for the companies listed on the market. Of course a company must react if it needs to change its strategy to avoid insolvency, but the need to change should not depend on a single day’s result on the market. It should be a longer term assessment. That is why we think it’s not a fair measure of the companies’ abilities to answer their liabilities in the long term.”
Dock is also critical of the impact of the red and yellow scenarios on pension funds’ equity holdings. PFA, the fund that saw its reserves wiped out last year, has been forced to reduce its equity allocation from 20% to 10% to enable it to move out of the yellow scenario. “The red and yellow scenario system forces you to be very wary of buying when the stocks are cheap. But we think it should be possible to measure when stocks are genuinely cheap. You can look at some key factors to find out are whether they are cheap or whether they are not cheap.”
The Forsikring & Pension are asking for adjustments to the system rather than wholesale change, he says. “We think it’s reasonable to compel a company to review their risks and their position, but the rules must be appropriate to the problems, You should be able to evaluate when a company is in real trouble and when it is in not that much trouble.
“We think that the rules we have at the moment do not take enough account of the real risk situation.”
The association has now asked for a meeting with DFSA. “We want them to discuss the system with us, and maybe change it a little to make it more adequate to the problems.” Says dock “We think that it could be changed without jeopardising the interests of the policyholders.”
Dock is hopeful that the system can be improved. “A dialogue will be established I am sure,” he says.
However, Nilsson at Alcifor is less optimistic. “The government is completely overwhelmed by the chairmanship of the EU. This means that nobody in government is likely to do anything at all until at least the end of December. Which is a sad story, because it is costing the country a lot of money.”