Sweden’s Financial Supervisory Authority (FSA) has dropped plans to change its traffic light model for insurance companies and pension funds after criticism that this would impose additional capital requirements on those companies.
Insurers and pension funds would effectively have been required to hold a higher percentage of their assets in low-risk instruments such as government debt to hedge their regulatory interest-rate risk under the new model.
This would not only have restricted investment choice but could also have weakened liquidity in the corporate bond and mortgage bond markets, according to the industry.
The proposals had been sent out for consultation last October.
In announcing that the plans would be scrapped, the FSA said: “Changes to the model could thus have major consequences for companies’ asset allocation and may ultimately also be liable to affect Swedish capital market stability.”
The traffic-light model was first introduced in 2006, replacing statutory restrictions on investment within insurance company portfolios by a principles-based approach.
Its aim is to identify – by carrying out stress tests for equity, credit, interest rate, real estate and currency risks – companies whose capital buffer is highly exposed to financial risks.
The model also includes stress tests for underwriting risks such as longevity risk.
The tests assess whether insurers and pension funds can meet their pension promise obligation, with companies given an overall rating of ‘green’ (low risk) or ‘red’ (high risk).
The ‘amber’ (medium risk) category was dropped some years ago because it was considered too ambiguous.
The FSA said it also identified a number of deficiencies in the existing model, not least because of continuing low interest rates.
Magnus Strömgren, deputy Executive Director for Insurance at the Swedish FSA, told IPE: “We tried to change the model into something more realistic, and there were areas where our proposals were more stringent than the existing model. But we made mistakes as well.”
Strömgren continued: “The existing model does not recognise that there could be negative interest rates. And it assumes there is no correlation between equity or interest rate shocks, and other asset classes, such as property. But in a stress situation, many things happen at once and cannot necessarily be said to be independent. Thus, the capital required in a severe financial stress is most likely underestimated by the current model.”
Rather than redesign the traffic-light system, the FSA will now ask insurers and pension funds to provide additional information on potential risks – such as credit risks – in their business activities.
This is intended to identify companies taking risks that might, given their financial situation and in a stress situation, threaten future pension payouts.
The FSA will then initiate a dialogue with those companies to agree a course of preventive action.
However, legislation setting up a framework for a new type of company, pursuing only occupational pensions business, is likely to be introduced within 3-4 years.
This will include new risk-sensitive capital requirements and could therefore allow the FSA to scrap the traffic light model or change it into something of a more targeted approach to certain risks, said Strömgren.