Hans Walter Scheurer discusses the recent European discussions on an appropriate European solvency regime for capital-backed occupational retirement provision

EU institutions have drawn a key lesson from the financial market crisis: nothing like it should ever happen again. In order to prevent crises more effectively in the future, the EU Commission has initiated numerous legislative initiatives and regulatory efforts that affect insurance companies and, in addition, Pensionskassen and pension funds. To what extent these ambitious projects reasonably reflect the price of additional security cannot be definitively assessed, at least from today’s point of view.

In September 2010, the European Parliament adopted the regulation establishing a European supervisory authority as part of the work programme of the EU Commission. The foundation was thus created for the establishment of a European Insurance and Occupational Pensions Authority (EIOPA), which began work at the start of 2011. In contrast to the predecessor Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS), EIOPA is now furnished with much more authority in relation to national supervisory authorities.

In addition to the newly established financial market supervisory authority, in April 2009 in-surance supervision law was fundamentally revised with the passage of the new European re-quirements for solvency capital, risk management requirements as well as disclosure and transparency provisions (Solvency II). The key objective of the Solvency II Directive initiated by the EU Commission is the establishment of risk-based solvency capital requirements that are linked stronger than now to the risks assumed by insurance companies. After adopting the framework directive, the quantitative requirements of Solvency II are now to be specified further before the end of 2011 by defining implementation measures. The implementation of Solvency II into national law is foreseen for the start of 2013.

Likewise in the context of the financial market crisis, the EU Commission published the Green Paper ‘Towards Adequate, Sustainable and Safe European Pension Systems’ in July of 2010. The EU Commission thereby introduced a Europe-wide public discussion as to how adequate, sustainable and safe pension systems can be warranted (across all pillars) and how the EU can best support national efforts. This objective is in principle worthy of support. From the van-tage point of occupational retirement provision, the Green Paper discusses critical topics such as the revision of the Pension Fund Directive to promote the single market for pension systems, portability of pensions within the EU and future solvency rules for institutions for occupational retirement provision (IORPs).

On 25 February 2011, the EU Commission published the results of the public consultation concerning the Green Paper and the further work programme. In all, member state govern-ments, national parliaments, social partners, representatives of institutions for occupational retirement provision and further stakeholders issued 1,700 replies. Without taking these con-sultation results into account, the report of the EU Parliament was passed in the plenum on 16 February, thus one week before the publication of the consultation results. In terms of further action, the EU Commission is planning for the third quarter of this year a White Paper regarding the issues in the Green Paper. In September of this year, a hearing is to be conducted regarding the revision of the Pension Fund Directive and a corresponding proposed directive is to be presented by December 2011.

Threat to pensions
If the approaches evident in these regulatory efforts lead to new legal regulations, they will pose a threat to supplementary retirement provision in Germany that should not be underestimated.

For example, the Green Paper rehashes positions from previously failed proposed directives on occupational retirement provision with the aim of establishing cost-inflating minimum standards that are to take effect in existing national regulations under the guise of portability. The EU Commission moreover refers in the Green Paper to preconceived positions on the re-vision of solvency capital requirements for IORPs, without having investigated their effects on supplementary retirement provision ex ante.

In this context, the European insurance industry has invoked the “same risk, same capital” ar-gument and demanded that Solvency II be applied to IORPs to assure a level playing field, even though serious differences exist between the insurance industry and supplementary retirement pension providers. Supplementary retirement provision is a voluntary social benefit provided as part of a total compensation approach linked to the employment relationship; it is not a financial product.

In addition, supplementary retirement provision is normally organised mutually by all parties to collective agreements, in some cases at the industry level, in order to warrant the best pos-sible representation of the interests of pension beneficiaries and sponsor enterprises. This also includes the organisation of IORPs as social institutions that are fundamentally orientated towards the securing of pension benefits and not for profit.

Balanced interests
In contrast to private insurance contracts, additional subsidiary liability on the part of the employer exists with respect to supplementary retirement provision - and thus a type of intrinsic reinsurance - for the promised benefits. Not least, supplementary retirement provision, in contrast to strictly private forms of insurance, recognises mechanisms to adjust pension and financing commitments in accordance with the solidarity principle to balance the interests of active and inactive scheme members on the one hand and pension carriers on the other as best as possible.

In relation to the aforementioned demand by the insurance industry, the Green Paper states that for the development of new solvency regimes for IORPs, “the Solvency II approach could be a good starting point, subject to adjustments to take account of the nature and duration of the pension promise, where appropriate.” A comparable position was adopted in the report concerning the Green Paper approved by the EU Parliament in February 2011. While the differences between supplementary retirement provision and life insurance companies were ex-pressly recognised, the EU Commission is called on to commission EIOPA to develop propos-als on decision-making in relation to IORPs solvency regime and “to launch an impact study on the application of a Solvency II-type solvency regime as soon as possible.”

A glance at the call for advice recently published by the EU Commission to EIOPA concerning the revision of the IORP Directive does not exactly raise hope for an adequate assess-ment of the special features of IORPs. Are the references to the special features of IORPs only empty phrases and is the “starting point” also the “objective” when key elements of Solvency II (eg, market value of assets and liabilities or the maintenance of own funds for a one-in-200-year event) are already firmly anchored in the call for advice? Were the consultations on the IORP Directive and the Green Paper thus only a ‘dance of the veils’? While, behind the scenes, the clear intentions have actually long been recognisable, as is clearly confirmed by the call for advice?

It is particularly notable that the EU Commission is again forcing a discussion regarding the transfer of Solvency II to IORPs precisely at a point in time when very strong opposition is building even in the insurance industry against the quantitative elaboration of the framework directive. From the viewpoint of the insurance industry, the fifth impact study conducted at the end of 2010 based on the balance sheet date of 31 December 2009 (QIS 5) clearly demonstrated weaknesses of Solvency II even before the rules have taken effect; ratios to be used to compute the solvency capital needs of insurers fluctuated much too sharply over the various stages of the impact studies.

Additional capital
Additional solvency capital will suddenly thus be required for the total of the insurance industry, even though this is not required by the actual liquidity situation. How the public would react if the sixth impact study were to be interpreted using the interest assumptions at the historically low level in September 2010 cannot be concealed; the contingency of Solvency II on cutoff dates would then be even clearer. The Solvency II approach thus contradicts one of the basic lessons from the financial market crisis: that supervisory elements with procyclical effects that intensify the crisis are to be avoided at all costs.

Pension commitments with long-term guarantees, whether from life insurance companies or from supplementary retirement provision providers, are put into a vice to a particular degree under Solvency II, because such commitments have to be backed in the future with enormous solvency capital requirements. Moreover, long-term investors who have to date exercised a stabilising function on the capital markets through investments in European equities, real estate or notes would be driven away from making such investments through exaggerated solvency capital requirements. While Solvency II would require maintaining 30% solvency capital for equity in the best rated European companies and 25% for high-quality real estate, investments could be made in Greek or Irish government bonds without any additional solvency capital. That the equity allocation of German insurers is so low is thus not astonishing. What guidance.

Whether the systemic criticism made by the insurance industry will be adequately taken into account through the EU Commission’s current proposal to grant transitory periods of up to 10 years for the switch to the solvency capital rules within the framework of the Omnibus II Directive can be left unresolved because the basic problem - that the Solvency II approaches are not compatible with supplementary retirement provision - will in no case be remedied as a result.

Even if no transitory provisions for the Solvency II model for IORPs have yet been stipulated in detail and therefore it is not clear what adjustments will be made of Solvency II to take the special features of IORPs into account, the starting point mentioned in the Green Paper is indeed very well known. Effects on supplementary retirement provision can thereby be analysed. The resulting figures are so alarming that, from a risk standpoint, this issue is no longer a matter of personnel policy for sponsor companies, but a matter of business policy, with the top management of sponsor companies having been tasked to deal with the potential consequences.

In Germany, Pensionskassen and pension funds would be affected by these regulatory efforts. Pensionkassen currently cover vested claims to supplementary retirement provision for a good €100bn. Current analyses made by Pensionskassen specialist working group of the Germany’s occupational pension fund association (aba) show, with respect to a representative German Pensionskasse, that if Solvency II is fully applied the funds currently maintained would have to be increased by eight to ten times - or even higher - depending on the organisation and investment structure.

In relation to all German Pensionskassen, this implies an allocation requirement of approximately €40-45bn. These dimensions are absolutely not sustainable and are a threat to all supplementary retirement provision. Moreover, the tax deductible of such resources to Pensionskassen and pension funds is also likely to have an impact on the fiscal situation of the state. Even if consideration of the special features of supplementary retirement provision were to still lead to a 50% reduction in the allocation requirement or if a transitory period of 10 years were to be additionally established, the scale of the burden would still not be sustainable.

When one reflects on the results of a simulated, unmodified application of Solvency II to IORPs, the question of the lessons learned for the future debate about adequate solvency capital requirements necessarily arises. The discussion of solvency capital requirements for IORPs cannot already be prejudiced - similar to the procedure for Solvency II - by first passing a framework directive for supplementary retirement provision as well and then later calibrating the model to any subsequent rude awakening about the true degree of the effects.

Such procedure would greatly unsettle the companies sponsoring supplementary retirement provision, funding carriers and, as a consequence, but not least, the affected employees. That the EU Commission overlooks precisely this fact and calls for the revision of the Pension Fund Direc-tive in the form of a framework directive in the call for advice to EIOPA and only then for ensuing consultation on the model calibration must be viewed as particularly critical from a business standpoint because it entails incalculable risks.

Based on the current debate, it is likewise clear that the short-term orientated view inherent in Solvency II is not consistent with the long-term commitments of IORPs. This contradiction, already experienced by life insurers, applies to supplementary retirement provision providers to an even greater degree because IORPs usually grant life-long pension benefits and only marginal cancellation rates exist as a result of labour law. IORPs can therefore withstand lows on capital markets without the procyclicality of other market participants - unless, of course, they are forced to do so by supervisory rules. Based on their sustainability and long-term na-ture, realistic averages and not current market values must be used to control supplementary pension models. Even in the case of extreme fluctuations, available liquidity is more impor-tant than the funding status on a valuation date.

Likewise, when debating adequate, sustainable and safe pension systems in Europe, the EU Commission must devote some critical reflection to the potential impact of rising solvency capital requirements. The funds necessary to meet the increased solvency capital require-ments would be locked up for decades and would thus not be available for actual operative business or necessary investments in the sponsor companies - together with continued subsidiary liability.

If every euro invested in supplementary retirement provision is thereby encumbered with enormous additional costs, this would signify for funded supplementary retirement provision the elimination of the foundation for business. The consequence would be either a shift away from the channels encompassed by the more stringent solvency capital requirements to internal financing via book provisions or a wholesale abandonment of supplementary retirement provision in the future. Today, international enterprises operate along the principle that compensation and benefits can no longer be considered in isolation in the context of a total compensation approach. Instead, the optimisation principle that money must flow where each euro invested has the highest value for the employee and the enterprise has to apply here as well.

Fast retreat
Therefore, if the money invested in supplementary retirement provision is encumbered with additional burdens to be maintained for a one-in-200-year event - even though the pension entitlements are accrued over 45 years and paid over 25 - enterprises will beat a fast retreat in the future away from supplementary retirement provision and back into cash compensation. Collective agreements (concerning retirement pension) enjoying the highest esteem and participation in Germany would also be affected by this retreat, because the existing salary sacrifice models would no longer be an attractive and reliable form of financing were supplementary retirement provision to be eliminated.

The demonstrated effects of including IORPs under Solvency II underscore the necessity of differentiated consideration. Freely transferring Solvency II to IORPs along the motto “the more the merrier” is neither reasonable nor expedient, because this will lead to economically unsustainable consequences for IORPs and employers, and thus supplementary retirement provision as one of the key pillars of retirement income in Germany and an attractive complement to the statutory pension scheme would be gravely threatened. Instead, IORPs require an independent supervisory regime. The currently applicable framework for solvency capital has proven adequate in two one-in-200-year events within a single decade in the form of the Internet bubble and the financial market crisis. In Germany. The real stress test has already passed with the current requirements for solvency capital.

Hans-Walter Scheurer is senior vice-president, compensation and benefits, at BASF and a board member of the German Occupational Pensions Association (aba)
This article was published in similar form in German in Betriebliche Altersversorgung 3/2011.