With full implementation now likely in 2014, Solvency II is looming. Rachel Fixsen examines some of the implications for Danish, Norwegian and Swedish pension institutions

The Solvency II regime is intended to regulate the insurance industry. But retirement providers are set to feel the impact more keenly in the Nordic countries where pensions are run by life insurance entities.

Nordic pensions institutions have long been preparing themselves for the upcoming implementation of the 2009 Directive, although, in some respects they have been aiming at a moving target. Details on the final shape and form of the Europe-wide regulation have been subject to delays, and crucial details - such as the precise capital charges for different investment instruments - are still not available.

Denmark’s pensions industry is seen as having had a head start in complying with Solvency II, since the national supervisor’s demands have long been similar. “Pension funds in Denmark have been working with mark-to-market and risk-based solvency for some years,” says Torben Møger Pedersen, CEO of PensionDanmark. “The transition to Solvency II is therefore expected to be less dramatic in Denmark than in other countries affected by the new regulation.”

In Sweden, an official Solvency II inquiry has been set up to implement the rules nationally, and work has progressed for more than 18 months. Delays at the European level to the publication of the final form of the directive have had a knock-on effect on the Swedish inquiry’s deadlines.

One major Swedish pensions insurer said it could not comment on the probable impact of Solvency II until the inquiry had concluded, and others are similarly reticent.

In Norway, the change in solvency regulation from the current Basel II-based model will effectively change pensions from “optimised savings” to a product where the provider has a secure ability to pay its liabilities, according to Helge Arnesen, CEO of Alfred Berg Kapitalforvaltning in Norway.

“What is creating a challenge, is that the life insurers have agreed with their customers to deliver annual positive returns - and that agreement is still in place,” he says.

But matching liabilities - as required under Solvency II - while at the same time maintaining a pledge on the annual return is costly, he says, and probably not in members’ long term interests.

“So you have to re-write the whole foundation of how pensions liabilities are provided for in the Nordics,” Arnesen says.

Guarantees swept away
Faced with Solvency II, many Danish pension funds have tried to reduce their commitment to the benefit guarantees they give as part of the traditional with-profits pension plans. Under the new European rules, these promises will force the funds to hold higher levels of reserves, which will curb the amount of investment risk they can take.

Those offering benefit guarantees are finding different solutions to the problem. Finanssektorens Pensionskasse (FSP) has made a gradual switch towards unit-link investment through negotiation, and has now reached the point where 75% of members and 50% of its assets are free of guarantees.

Industriens Pension, on the other hand, is practically switching its entire scheme to unit-link in one move, simultaneously boosting member’s accounts by approximately 20% through the distribution of the collective savings pool that is no longer needed.

Labour market scheme, Sampension, drew controversy last year by simply withdrawing benefit guarantees on all its pensions, albeit with the approval of the collective bargaining parties.

Danish results of the Europewide QIS5 stress tests earlier this year saw the failure of life insurers and pension institutions. Meanwhile, in Sweden, the tests showed that all pension and life insurance companies were above the minimum capital adequacy levels required.

Consultancy Kirstein Finans has said it expects Solvency II to exert a strong influence on both the structure and investment strategies of the pensions sector, albeit gradually, as the 2013 implementation date of the directive approaches.

Given the huge demands the regulation places on organisations in relation to education of those in top management as well as on models, reporting and other areas, one could have expected a certain degree of consolidation to have happened already. But so far, the only formal merger had been between four pension funds under the umbrella of PKA, which were already co-operating beforehand.

There is little doubt that pension funds with traditional guaranteed savings products will see higher administrative costs under Solvency II, Møger Pedersen says. He also predicts further consolidation in the sector because of this, or at least closer co-operation among smaller pension funds. The Directive requires firms to establish four functions as part of their system of governance - risk management, compliance, internal audit and actuarial.

Solvency 1.5 - a halfway house
Many of the governance requirements under Solvency II were demanded by the Danish regulator from 2006 onwards, when it implemented the Danish Individual Capital Requirements, known as ‘Solvency 1.5’, Morten Lund Madsen, head of risk management at PKA, points out.

Now that this has been updated to converge with the Solvency II requirement, he says PKA and other Danish pension funds are already calculating the solvency capital requirement - which is similar to the SCR under Solvency II - and are producing a report similiar to the ORSA (own risk and solvency assessment) report, which will be required under the directive.

The ORSA report is a big part of Solvency II’s Pillar 2. The aspect of the directive focused on the supervisory activities of regulators, aiming to ensure these authorities can identify firms with a higher risk profile.

PKA is ready for three of the four functions - the qualitative aspects of Solvency II - with risk management, compliance and actuarial already in place, Lund Madsen says. “The only outstanding is the internal audit function, and we will work on that soon, once the precise requirements have been laid down. “The big task for us is setting up the IT and data for carrying out the quantitative data work. This will require a combination of new systems and making changes to existing ones,” he says.

PensionDanmark is one pension scheme that never offered guarantees on benefits. Members’ savings are invested in unit-linked products. With members shouldering the investment and longevity risk, the fund will be less affected than other funds in some ways - on asset allocation, for example - though it will be subject to the more stringent reporting requirements.

The experience with Solvency 1.5 led to a more holistic view of risks, Møger Pedersen says.

“Earlier on pension funds were good at managing and monitoring their investment risks, in particular their interest rate risks. But the work with other types of risks, such as operational risks, longevity risks and reputational risks etc, has been improved significantly under the Solvency 1.5 framework.”

PensionDanmark has already adopted a Solvency II compatible structure with a risk function - which is independent of the investment team - an actuarial function and a compliance function.

“Our internal auditor will oversee the processes in the three functions. We still have some way to go on the reporting requirements but that will be in place well in advance of the implementation of the new regulations,” he adds.

As far as the administrative cost of compliance goes, PKA sees the overall cost of Solvency II coming in at close to DKK40m (€5.4m). “It’s quite a big project, and we have a lot of our processes and administration outsourced to Forca; they’re running a big programme for Solvency II,” says Lund Madsen.

But PensionDanmark does not foresee a big impact on its administrative costs, because of work already done. “Early on, we identified the skills needed to cope with the new regulations and we believe that we have the right people in place,” Møger Pedersen explains.

PKA does not see the directive driving any changes in the make-up of its investment portfolio, though the interest-rate hedging strategy could change. “The interest-rate curve in Solvency II is not finalised,” Lund Madsen notes. “At the moment, the curve cuts off after 20 years. If that’s the final solution, it might affect our interest-rate hedging.”

The Danish FSA has been fighting a long battle to get a longer yield curve used for discounting liabilities across the EU, he says, as this is what Denmark is using today. Most Danish insurers and pension funds do not want a special solution for Denmark and prefer the same curve as the rest of Europe as this would create a level playing field, he says.

Norwegian hitches
In Norway, pensions insurance institution Oslo Pensjonsforsikring expects to be impacted by the new regulations, according to its chief investment officier Kjetil Houg.
In terms of qualitative risk management, the advent of the rules has prompted the organisation to prepare for a greater emphasis on process and data documentation, reporting standards, he says. On top of this, it will work to accommodate improved transparency in valuation and valuation methodology, he says.

Internal structures are seeing alterations too. “Solvency II encourages a more cross-sectoral approach to compliance and risk management. We have initiated changes in the way we operate here,” Houg says.

On asset allocation, he says the current capital charge structure contained in the directive clearly favours state-guaranteed loans and asset-backed securities while discouraging low volatility alternative assets. “This might affect allocation during a period of solvency stress,” he believes.

As far as bond holdings are concerned, Oslo Pensjonsforsikring’s portfolios typically consist of high-grade bonds, but Houg notes that a question mark still hangs over unrated instruments, regardless of credit.

Norwegian pension institutions tend to be heavy investors in municipal bonds, but these widely trusted instruments are generally unrated by credit ratings agencies.

Pension institutions will be more interested in rated bonds as a result of the Solvency II requirements, Arnesen says, and this could create difficulties in the funding of non-rated issuers in the Norwegian market.

But Houg believes the ratings problem could disappear. Many of the municipalities and savings banks issuing the bonds will reconsider their rating strategy when reform arrives, he believes, though no co-ordinated efforts are currently planned.

Nethertheless, Arnesen sees the big bond-related challenge in the lack of duration in the market. “There are not enough krone-denominated bonds with the duration to match pension liabilities,” he says.

On the matter of costs, Houg notes that the tougher requirements on risk management, documentation and reporting standards will all cost money. And on top of this, stimulating allocation in low yielding investments will - all else being equal - reduce expected return and so increase pension costs over time, he says.

That said, he remains optimistic about reaping a decent expected return for Oslo Pensjonsforsikring’s clients after implementation.

As part of the banking group DnB NOR, Norway’s life and pensions insurer Vital Forsikring is preparing for the new regime by running a comprehensive Solvency II programme at group level, according to Vidar Korsberg Dalsbø, communication adviser at the group.

“Our vision for risk management goes beyond compliance,” he says. “Preparations for Solvency II target finding optimal adaptations to the new regulation in implementing Solvency II; the ambition is to raise risk management to the level of Nordic top class.”
As part of the banking group, Vital Forsikring has already practised risk management in line with Basel II implementation, he says. “The Solvency II rules are different, but the structure is familiar.”

Vital will only need to make minor adjustments to internal structures, Dalsbø says. For example, it had decided to group two lines of risk functions within one organisation, appointed a CRO, and is clarifying the roles and responsibilities between different risk functions within the group, he says.

Asset allocation
Peter Nielsen, head of the Nordic region at asset manager BlackRock, sums up how pension insurance companies in the area will need to change their investment strategy: “They need to remove unrewarded risk; they need to make sure they get the return on the upside of the risk they take.”

Though the QIS5 gave some indication of how asset allocation could affect solvency under the new criteria, he still sees several unknowns surrounding asset allocation. “As we don’t know the likely outcome of Solvency II - the capital charges - we don’t know how expensive it will be to hold equities.”

But in Denmark, at least, if some of the yield guarantees are maintained on the traditional with-profits plans, the pension funds offering these may be forced to invest in higher-yielding assets, Nielsen notes.

“Some people have guarantees of up to 4.5%, but in the current environment it is hard achieve that,” he says. “They’ll have to look for higher returns, from hedge funds, high-yield bonds, for instance.”

Under Solvency II, it is not only the type of investment instrument that is important in determining the level of capital required, but also the transparency of the underlying investment. “If you don’t have visibility, you’ll have to set the risk bar higher,” Nielsen cautions.

When the new regime is in place in Norway, Arnesen sees pension companies’ allocations to equities moving down to between 10% and 20%, from the current average objective of 30%. “You are looking at equity not as a mainstay for providing return, but more for its diversification properties,” he says.

Property allocations are also likely to reduce relative to overall portfolios. “It will be hard to hold large real estate holdings, because they differ too much from liabilities,” he says. “Property is hit quite hard under Solvency II.”

Taking a step back from the details of Solvency II implementation, Arnesen sees dangers ahead for Norway’s defined benefit pensions systems. These come not from the Solvency II regime on its own, but from the combination of those rules and other regulation affecting the providers.

Until all the relevant regulatory aspects, including accounting rules and those on pension payments, are in lockstep, he sees it as impossible for pension funds to make the necessary changes.

“It all has to be synchronised; the lack of synchronisation could be the death of defined benefit,” Arnesen warns.