Price for Norwegian DB guarantees
The Norwegian pensions oligopoly can only be challenged if employers transfer pensions to an IORP structure, argues Christian Fotland
The Norwegian defined benefit market is subject to strict rules relating to the structuring of the pricing and reserving of annuities - the minimum funding of defined benefit (DB) schemes. The rules apply to pension funds and insurance companies alike. This is apart from the institutional framework for pension funds and life insurers and represents the Norwegian implementation of the EU's occupational pensions and life insurance Directives.
The cashflows in an annuity are guaranteed subject to administration, mortality and disability risks. The reserve equals the net present value of the expected cashflows discounted back with a fixed discount rate. The maximum fixed discount rate allowed is determined yearly by the regulator, based on its interpretation of the 60% discount rate rule in the EU solvency regulations for life insurers. The discount rate in the defined benefit market is in the 3-3.6% range. The current government bond yield is around 2.58% for the zero coupon one-year certificate and 4.1% for the 10-year bond.
Life insurers' reserves are backed by assets - stocks, bonds, real estate. The annual accounted-for return on assets, less the unwinding of the discount rate for the year, equals the net investment result. If the net investment result is negative, the life insurer must pay out of its solvency capital and the client keeps the positive net investment result. However, the life insurer can decide that all or part of the positive net investment return is to be used as a buffer fund.
In other words, the life insurer has sold the client a put option, or guarantee, on the return of the asset with a strike rate equal to the higher of the discount rate less the buffer fund, and zero. The life insurer decides on asset allocation and hence volatility in the annual return. In theory, the insurer could choose a classic structured product strategy with a bond allocation and call option to capture the upside of the equity market.
Prior to 1 January 2008, the annuity was considered a with-profits annuity. A life insurer could legally carve out up to 35% of the profits in the with-profits book. It was a market benchmark at that time that the carve-out was targeted at 0.4% of the reserves. The solvency capital requirement was in the range 5-6% of reserves. The rate of return on solvency capital in addition to the return on the assets backing the solvency capital was 0.4/5=8%. This was, at the time, a reasonable marginal return.
However, from 1 January 2008, the with-profits annuity structure was prohibited by law and was replaced by a methodology whereby the life insurer charges a premium up-front for the put option.
The pricing for 2008 (decided in December 2007) was not surprisingly centred around 0.4-0.5%, with one insurer charging 0.7% on average. Pricing also depended on the effective strike rate. A strike rate of 3% required a higher option premium than a strike of 0%, of course. Some insurers offered their clients a choice between different asset portfolios branded as ‘low risk', ‘medium risk' and ‘high risk'. Here, the insurer decided on asset allocation and did not guarantee that the ‘high risk' option had a higher risk profile than the ‘low risk' brand. The option price was, of course, much higher for ‘high risk' than ‘low risk'. Unsurprisingly, most clients opted for the ‘medium risk' option.
Last year was a turbulent year in asset markets. Life insurers started 2008 with a 20% allocation to equities and, through dynamic rebalancing, ended up at around 4%, touching on the strike for the put option. In December 2008 it was time for renewal pricing of the option. Most clients had depleted their buffer funds so the strike rates would be in the 3% area. Interest rates were down and 12-month risk free rates were less than 3%. Real estate assets had a bearish outlook and so 0.5% seemed to be the market price.
In the Norwegian defined benefit market, three insurers compete for 90% of the business. This oligopoly can only be challenged by clients transferring their pension assets into pensions funds (IORPs). Even if pension funds have to follow the legislative rules with put option, or guarantee, pricing, everybody understands that you cannot benefit from writing a put option on your own assets. This means that pension funds are a clear alternative to those clients who do not accept the vague concept of put option pricing on an asset allocation determined by the option seller.
The 2010 season has now started. One insurer has declared that due to low interest rates and the volatility in the financial markets, it would have to increase prices by 5%. That appears to be a modest price increase. But it is not what it seems. This 5% increase was expressed as an increase in the expected 2010 contributions to the pension scheme, and contributions to pension schemes average 18% of reserves. Therefore, the increase was actually an increase of 5% of 18%, that is, 0.9% on the reserves. The expiring price was 0.5% and new price was actually 1.4% - an increase of 280%.
Whether the insurer can actually get the market to pay the announced price is yet to be seen, but a return on solvency capital of 1.4/5=280% in surely worth a try. The stock market picked up on the changed prices two weeks later. At least one analyst changed his recommendation on a major Norwegian life insurer from ‘sell' to ‘buy'.
Christian Fotland is senior pension analyst and general manager at Gabler Wassum in Oslo