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The Actuary The magazine of the Institute & Faculty of Actuaries
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Solvency II: Market-inconsistent?

In its letter to Alistair Darling (Financial Times 1 September 2009) the Association of British Insurers warned that Solvency II’s ‘extreme’ proposals represented a threat “to the industry, to its customers and even to financial stability”.

They cautioned that the impact of the proposals would be to increase capital and reserve requirements of British insurers by a staggering £30bn, and that “this huge over-capitalisation will mean investment returns in insurance will fall, companies will exit the market, prices will rise, cover will reduce and innovation will lessen”.

Industry lobbying has concentrated on capital requirements and the valuation of technical provisions. However, it is our belief that there is an area which offers potentially significant and, importantly, justified improvements in firms’ capital positions. This is that age-old headache of many UK companies — the deficit in their defined benefit pension fund (DBPF).

The total accounting deficit in UK private sector pension schemes registered £189bn (Source: Pension Capital Strategies) at the end of March 2010. Solvency II valuation rules require the full value of DBPF deficits to be included in the assessment of available capital resources. Proposed revisions to the IAS19 accounting standards will increase the size of firms’ reported deficits, thus having a further detrimental effect on capital resources. Our opinion is that, as a long-term commitment that does not require immediate funding, the deficit should be ignored when determining available capital for solvency purposes.

This assertion may be contentious but we believe that there are several good reasons for this position to be taken. What happens to our pensions if the sponsor goes bankrupt? As an unsecured creditor, pension liabilities rank lower than policyholders and secured creditors. The Insurers (Reorganisation and Winding Up) Regulations 2004 state that: “The debts of the insurer must be paid in the following order of priority:
(a) Preferential debts
(b) Insurance debts
(c) All other debts.”

In the case of insolvency, any capital tied up in the pension deficit would first be used to make payments to policyholders. Since the capital adequacy regime is designed for the protection of policyholders, the fact that this capital is available to meet their claims suggests that it should be included in the available solvency capital. This is consistent with the deficit being ignored.

When is an insolvent or solvent company potentially the opposite?
Let us now consider an example of Company X, with a deficit in its DBPF (see Figure 1). Under Solvency II rules, Company X is currently solvent with net assets of £275m, exceeding the capital requirement of £200m. Suppose, all else being constant, Company X’s pension liability is recalculated as £200m. In this case, Company X may be considered ‘insolvent’. However, if the DBPF deficit is ignored, there are more than sufficient assets to meet all other liabilities and the regulatory capital requirement. Is it fair that Company X is considered ‘insolvent’ under this scenario? Company X’s core business is to write insurance contracts, and there is no evidence to suggest that it has been unsuccessful at doing so.

Given the situation above, would employees and regulators want Company X to reduce its operations or even close to new business and enter run-off? For employees, this would lead to an eventual loss of employment and the likelihood that their pension promises would not be met (at least not in full). Rational employees would want Company X to continue as a going concern with the hope that the pension deficit would be met in the future via additional contributions as and when they are affordable.

In February 2009, The Pensions Regulator stated: “Where the sponsor company is under pressure there is potential to renegotiate previously agreed plans to repair pension deficits. There is no reason why a pension scheme deficit should push an otherwise viable employer into insolvency.” This appears to suggest that, for solvency purposes, the available capital for Company X would be the difference between assets and liabilities excluding the pension liability. Employees and trustees are indicating that the deficit does not need to have assets set aside to cover it immediately.

Conversely, suppose Company X had a DBPF surplus and that available resources exceeded capital requirements with the inclusion of the surplus, but not without. This would provide a false sense of security to stakeholders under the proposed Solvency II valuation. However, this surplus would not normally be accessible for policyholder protection.

There are several examples of companies whose pension deficits render them insolvent, but are still allowed to operate as going concerns. The most notorious example is that of the UK’s flagship carrier airline, British Airways (BA).

What is a market-consistent treatment of pension deficits?
In Figure 2, if the pension deficits of BA’s two pension schemes had been recognised, then the firm would no longer have positive net assets. Press reports in Q4 2009 suggested that the pension deficit could be higher than £3bn. Under Solvency II-type rules, BA would be ‘insolvent’ to the tune of over £1bn. If BA were forced to fill its £3bn+ pension deficit over the next 5-10 years, then there would be little or no surplus cash left to pay dividends.

‘Fundamental’ share price valuation considers the net asset value per share, and the present value of future dividends. Given BA’s situation above, the current share price which hovers around £2 appears inconsistent with fundamentals. In fact, it appears consistent with the exclusion of the pension deficit.

The arguments above appear to suggest that investors, auditors, regulators, and employees appear to make an assessment of the state of the company with the deficit ignored. Since these stakeholders are constituents of the market and the share price itself is inconsistent with the deficit’s inclusion, we can consider this to be market-consistent practice. If this is the case, shouldn’t this approach be reflected in Solvency II, where market-consistent valuation is an overriding principle?

Can a recalculated deficit make an insurer insolvent overnight?
Valuation of DBPF funding levels is subject to considerable volatility. A situation could therefore materialise whereby a solvent company recalculates its DBPF and, as a result, is suddenly insolvent (for example, Company X).

The deficit has a considerable effect on an insurer’s financial position but is inherently difficult to manage — the valuation and the assumptions affecting it are outside the control of the normal business operations of an insurance company. If managers are forced to devote considerable resource to managing the deficit in their pension fund, it is likely to be at the expense of other capital and risk management, which is not in the best interests of policyholders. Focus should be on protecting policyholders, not the potential ‘insolvency’ caused by having an out-of-control pension deficit. The best way to ensure that this is the case is to recognise that, given its long-term nature, the deficit does not need immediate attention, and hence eliminate it from the solvency balance sheet.

What is the FSA’s view?
The latest annual report (31 March 2009) of the Financial Services Authority (FSA) shows liabilities exceeding assets by £123m, of which £89m is its DBPF deficit. It states: “...Our financial statements have been prepared on a going concern basis. Excluding the pensions deficit measured on an IAS19 basis, we had a net deficit of £34.2m...”

The fact that the FSA disregarded the pension deficit when justifying its consideration as a going concern appears to suggest that the deficit is being ignored in the demonstration of immediate or short-term solvency.

Conclusion — how should pensions be treated by a market-consistent regime?
Our arguments illustrate that the current treatment of pension deficits does not appear to be market-consistent. Various market participants, including shareholders, employees, policyholders and the regulator, do not regard the deficit in DBPFs as an immediate liability. Furthermore, including the liability in the solvency balance sheet is disadvantageous for policyholders. The volatility it will produce will lead to greater uncertainty, while CEOs and risk managers will be forced to focus on managing the pension liability at the expense of other areas of risk and capital management. Why then, does Solvency II, a market-consistent regime aimed at increasing policyholder protection, take a conflicting approach?

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Niraj Shah and Thomas Quirke are both actuaries working for Groupama Insurances
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