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Western EuropeFebruary 1 2012

Using a sledgehammer to crack a nut

In response to a request from the European Commission, a recent consultation paper from the European pensions body looks at ways the proposed Solvency II directive for insurers could be applied to occupational pensions. Many in the industry see far more problems than solutions in its application
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What is it?

The obscurely titled 'Call for advice on the review of directive 2003/41/EC: second consultation', from the European Insurance and Occupational Pensions Authority (EIOPA). Driven by the European Commission’s wish to extend Solvency II (a directive aimed at the European insurance industry) to pensions, this consultation paper outlines the way in which the directive could be applied to occupational pensions via changes in Europe’s Institutions for Occupational Retirement Provision (IORP) directive.

The 517-page paper was published in October 2011 for review by the industry in a consultation period which ended on January 2, 2012. EIOPA only has until February 15 to digest the industry's responses before it must put forward its final proposal to the European Commission.

What is Solvency II?

Solvency II is a wholesale review of the capital adequacy regime for the European insurance industry, which aims to establish a revised set of EU-wide capital requirements and risk management standards. It will achieve consistency across Europe on the key ideas of: market-consistent balance sheets; risk-based capital; own risk and solvency assessment; senior management accountability; and supervisory assessment.

Now is the time to build a modern and innovative system founded on risk management, corporate governance and effective supervision, inspired by Solvency II and taking into account the special characteristics of institutions for occupational retirement provision

Michel Barnier

Solvency II will also be more comprehensive than in the past. Current EU solvency requirements concentrate mainly on the liabilities side (ie. insurance risks), but Solvency II will also take account of the asset-side risks, creating a total balance sheet-type regime. Insurers will then be required to hold capital against market risk, credit risk and operational risk, currently not covered by the EU regime.

Why apply it to pensions?

The European Commission argues that it is appropriate to introduce further risk-based supervision of pension institutions and to modernise prudential regulation for pension schemes. In a speech to EIOPA's annual conference in November 2011, the EU's internal markets commissioner, Michel Barnier, also said Solvency II reform would facilitate cross-border pension provision. Currently there are only about 84 schemes operating cross-border within the single market.

Mr Barnier said: “Now is the time to build a modern and innovative system founded on risk management, corporate governance and effective supervision, inspired by Solvency II and taking into account the special characteristics of institutions for occupational retirement provision.”

What does the industry say?

The industry sees the benefits in some areas, but is worried about the impact in others. In its response at the end of December 2011, the European Federation for Retirement Provision (EFRP) welcomed more risk-based regulation of IORPs, especially in the fields of risk management, governance and communication to members, but argued that capital requirements for IORPs should not be based on Solvency II legislation for insurance companies.

Rage-ometer

The EFRP warned that this kind of regime for pensions would have a negative impact on pension plan sponsors, members and beneficiaries, as “inappropriate” solvency requirements would likely lead to an unnecessary reduction in benefits and higher contributions. It is also concerned that the move to accounting for pension liabilities by using a “risk-free” rate of return, as would be required under Solvency II proposals, would lead to greater concentrations of exposures to sovereign debt.

The Association of British Insurers is also opposed. More work needs to be done, says Jonathan de Beer, policy advisor to the ABI. “One of the criticisms we have of the EIOPA consultation is that it contains plenty of policy options for application but no impact assessment on pension schemes,” he says.

How much will it cost?

The ABI is particularly worried about the impact on defined benefit schemes, of which by far the largest proportion is domiciled in the UK.

Analysis of the estimated total asset and liabilities of the UK's defined benefit pension sector by JPMorgan Asset Management suggests such schemes could face a capital shortfall of up to £600bn ($915bn), which would have to be met by schemes and their sponsors.

Terry Simmons, partner in financial services at Ernst & Young, says the defined benefit market in the UK has a total value of about £1000bn, and Solvency II would potentially add 50% to the costs of servicing the schemes. “It is hard to give a precise figure until we have more detail, but we estimate that the cost of Solvency II could be in the region of £300bn.”

The JPMorgan report suggests, anyway, that Solvency II is the wrong approach for pension schemes. It says: “We question... whether a prudential framework that is designed for application to large-scale and active insurers (the proverbial sledgehammer) is appropriate for consistent application to pension schemes (the nut).”

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