The Removal of Interest Rate Guarantees in Life Insurance- and Pension Companies

Transcription

1 The Removal of Interest Rate Guarantees in Life Insurance- and Pension Companies -With Respect to the Danish Discount Curve Authors: Mari Fløgstad Skipevåg and Ingrid Haugseng Aarhus University, Department of Business and Social Sciences MSc in Finance Master Thesis 2013 Academic Supervisor: Peter Løchte Jørgensen

2 Abstract This thesis analyses the fair valuation of embedded interest rate guarantees in Danish Life Insurance- and Pension contracts, in order to remove them from the balance sheet. This is motivated by the current low interest rate environment, which have made the interest rate guarantees to become deep in-the-money, and have grown to become a substantial obligation for L&P companies, pressuring their solvency. An analysis of the Smith Wilson method used for discounting long-term liabilities in Denmark indicates that the method does not provide a fair discount curve. In order to buy policyholders out of their guaranteed contracts, the fair value needs to be established. We use the model by Grosen and Jørgensen to find the fair value of a participating contract with embedded guarantees, where the guarantees is found to be highly sensitive to interest rate changes. Hence, it is concluded that policyholders miss out on a significant value when being compensated by the Smith Wilson yield curve, rather than a fair discount rate.

3 Table of Contents 1.0 Introduction Problem Statement Refinements and Definitions Outline The Danish L&P System The Three Pillars System Pensions Schemes Danish Pension Products Pension Contracts The Crisis in the Danish L&P Sector Accounting Standards and Regulation An Overview of International Financial Reporting Standards Solvency II The Traffic Light System The New Liability Side Interest Rate Sensitivity in the L&P Sector Assets Liabilities The Balance Sheet Duration Asset Liability Management The Danish Discount Curve The New Discount Curve Smith- Wilson Method Implications of the New Discount Curve Changed Liability Values Hedging the UFR Curve Evaluating the Factors in the Smith- Wilson Method The Liquid Part of the Curve... 41

4 8.2 Ultimate Forward Rate Last Liquid Point Convergence Period Speed of Convergence Concluding Remarks on the Smith- Wilson Method Fair Valuation of Liabilities The Model by Grosen and Jørgensen The Model by Charlier and Kleynen The Model by Anna Rita Bacinello Concluding Remarks on Fair Valuation The Removal of Interest Rate Guarantees The Fair Compensation for Giving Up an Interest Rate Guarantee Effects of the Removal of Interest Rate Guarantees Conclusion List of References Appendix 1: VBA Codes... 80

5 List of Figures Figure 1: Pension contracts by risk exposure Figure 2: European participating contract Figure 3: Declining interest rate on Danish 10Y government bonds since the 1980's Figure 4: Asset-liability mismatch of L&P companies balance sheet Figure 5: Liability discount curve vs. Danish government bond yield curve Figure 6: Smith-Wilson forward yield curve vs. Danish government bond yield curve Figure 7: New vs. old hedging strategy Figure 8: Smith-Wilson forward- and spot rates yield curves Figure 9: Historical annual inflation in Denmark Figure 10: GDP growth rate in Denmark Figure 11: Smith-Wilson forward rate yield curves with different UFR Figure 12: Forward rate curve with different convergence periods Figure 13: Speed of Convergence Figure 14: Decomposed contract value with different discount rates List of Tables Table 1: The Danish Pension System... 6 Table 2: Option elements of a pension contract Table 3: Decomposition of the liability side Table 4: Interest rate guarantees in the L&P sector Table 5:Discount rates in the GJ model Table 6: Decomposed contract value with different discount rates Table 7: Decomposed contract values with different guarantees Table 8: Compensation for interest rate guarantees in PFA Pension Table 9: Compensation given in L&P companies... 66

6 1.0 Introduction People want to maximize their welfare through the entire lifetime. However, individuals are generally neither suited nor willing to make investment decisions concerning future income; thus to maintain a certain standard of living after retirement, pension companies get involved to hold and invest peoples savings. The Danish pension system has enjoyed international credit as a particularly effective and solid system, and in 2012, Denmark was awarded the worlds best pension system, as the first to receive the highest grade A (Andersen 2013, pp. 29). But during the last decades, even the best pension system in the world has experienced economic difficulties and solvency problems. In the beginning of the 1980 s, pension contracts including high interest rate guarantees of 4,5%, were issued in Denmark to give pension savers an additional security, by promising a minimum annual return on their contributions. At this point in time, market interest rates were as high as 20%, thus the guarantees were of little or no value. However, in the following decades market interest rates declined sharply towards historically low levels, even below the issued interest rate guarantees. The situation has left the pension companies with increasing contract values, since the guarantees have gone from far out-of-the-money to deep in-the-money, and turned into a significant liability for the Danish pension sector. The falling market interest rates also made it difficult for pension companies to achieve high returns on investment portfolios, and by the Global Financial Crisis of 2008, the situation was worsened substantially. Poor asset returns combined with increasing liabilities created difficulties in covering the pension savers annual guaranteed return, and led to solvency problems. To reduce interest rate and equity risk, hedging by the use of derivatives has been a successful solution in Denmark (Ladekarl, Ladekarl et al. 2007). However the problem of underfunded pension liabilities is still present, and pressures the solvency of the L&P sector. The pension sector constitutes a fundamental part of the economy; hence it should be of common interest to find a permanent solution to the disturbances in the sector. Governmental intervention has in the last years increased in Denmark, resulting in stricter regulations and restructuring of the sector. As actions to improve the situation, the Danish Ministry for Business and Growth imposed new valuation techniques for long-term pension liabilities, and encouraged a removal of the minimum return guarantees. Many life insurance- and pension companies have already started the process of buying customers out of the guaranteed contracts. Due to this, it is interesting to investigate if policyholders receive the fair value of their interest rate guarantees. 1

7 1.1 Problem Statement Our purpose with this thesis is to provide a greater understanding of the valuation process underlying the removal of interest rate guarantees, in an attempt to show policyholders what the fair value of their contracts are. In order to examine the fair value of the interest rate guarantees, this paper will first seek to find the fair discount rate, by analyzing the model used for discounting longterm pension liabilities in Denmark, and aim to answer the question: Does the Danish discount method for long-term liabilities provide a fair discount curve? The fair value is essential when pension companies are removing their guarantees in order to compensate policyholders for what they are giving up. If the Danish discount curve is proven fair, this discount curve will be used to find the fair value of the guarantees. But if the Danish discount curve is proven unfair, we will use a fair valuation model to compare guaranteed values with an unfair- and fair discount rate. The removal of the guarantees will have large impacts for both policyholders and the entire sector, which leads us to the last question: What are the effects of removing the interest rate guarantees seen from policyholders and Life Insurance- and pension companies point of view? 1.2 Refinements and Definitions In this paper the focus is on products in Danish life insurance- and pension companies, and in the following we will refer to these companies as L&P companies, and the customers of these companies will mainly be referred to as policyholders. Our problem statements is also relevant for L&P companies in other countries, but with respect to differences in regulations and laws across borders, we need to limit our analysis to Denmark. When we write guarantees in this paper, we refer to interest rate guarantees. And if nothing else is stated, we refer to interest rate guarantees of 4,5% after tax, since these guarantees represent the highest risk for L&P companies. But the principles of the interest rate guarantees could also be extended to other guarantees, as maturity guarantees. We chose to not consider mortality- and disability issues in our thesis, and do not take into account taxes and subsidies. Whenever relevant, we will make ongoing delimitations. 1.3 Outline In order to understand the nature of the L&P contracts, section two explains the structure of the Danish pension system, with the three-pillar system as a basis. This is elaborated by the two general 2

8 pension schemes, the defined benefit- and defined contribution plans, and the section is continued by explaining the most common products embedded in these arrangements. In section three, an explanation for why the interest rate guarantees have become a problem in the Danish L&P sector is presented. The situation was worsened by the implementation of new accounting standards and regulations, and those relevant for the L&P sector is presented in section four. To understand the underlying issues connected to the interest rate guarantees, section five investigates the interest rate sensitivity of L&P companies balance sheet. The liabilities are much more sensitive to interest rate changes than the assets, and to deal with the duration mismatch section six looks at different ALM strategies that have been used by the sector. But derivatives are expensive and the solvency risk is still present in the balance sheet, so the focus in this thesis is to remove the interest rate guarantees. The Danish Financial Supervisory Authority (FSA) imposed a new discount curve for long-term pension liabilities, constructed by the Smith-Wilson method. Theoretical aspects of this model will be discussed in section seven, where the implications of the model are discussed in section eight, and in section nine we evaluate each of the input factors in the Smith-Wilson discount curve. In order to give a fair compensation to policyholders for their guarantees, the fair value of the interest rate guarantees has to be underlying. In section ten we find fair values of participating contracts with the use of the model by Grosen and Jørgensen, and investigate through a sensitivity analysis the impact of different discount rates. In addition we explain two alternative fair valuation models that extends the model by Grosen and Jørgensen. In section eleven the actual practice for compensating policyholders are presented, and the last section looks at the effects of the removal of the interest rate guarantees seen from policyholders and L&P companies point of view. 3

9 2.0 The Danish L&P System A pension scheme is an arrangement with the intention to secure financial resources for people at retirement, also for those who either cannot or will not contribute to the value creation in a society (Barr and Diamond 2006). Trying to optimize the standard of living through a stable consumption is called consumption smoothing, and a pension scheme can contribute to this by helping people transfer consumption from productive working age to retirement. The L&P system also provides a poverty relief by ensuring that everybody is taken care of at retirement by receiving a minimum base of capital, including those who have managed to save less during their lifetime. In this way, we can see that an L&P system has a redistribution effect by transferring income within and between generations, and at the same time works as insurance against uncertainties of life. The L&P industry constitutes a large segment of the financial system in Denmark and its significance can be described by the total value of contributions into Danish L&P plans. In 2011 it was 2643 billion DKK, corresponding to 1,5 times the size of Denmark s GDP (Andersen 2013, pp. 30). GDP is defined as the value of all finished goods and services produces in the economy within a time period, usually a year (Investopedia). This emphasizes the importance and scope of the L&P system in the Danish economy. The Danish Economic Council estimates that by 2045, 70% of the pension benefits will come from private pension savings and only 30% is financed through taxes by the state. This means that the future welfare of policyholders is increasingly dependent on private contributions and L&P companies ability to manage a high performance on these contributions, hence a well-functioning L&P system is essential (Andersen 2004). In the following we will explain the three pillars system of the Danish L&P sector, followed by an elaboration on the two major pension schemes. Finally we will describe common products used in combination with these schemes. 2.1 The Three Pillars System The Danish L&P system consists of three pillars, the social-, occupational- and personal pension. The effective interaction between them is one of the main reasons for the credit Denmark has received for its pension system. Each of the pillars are either organized as fully funded or unfunded (Ladekarl, Ladekarl et al. 2007) Social Pension The primary schemes in the social pension are the old-age pension and the supplementary earningsrelated plan (ATP), where both are statutory. The old-age pension is an unfunded public pay-asyou-go system, where the current workforce is taxed to finance the pensions to the retired generation, i.e. an intergenerational transfer. Since the tax rate is not fixed, there is a chance that the contributions made by current work force are unequal to the pension payments they receive at 4

10 retirement. Regardless of this, the system ensures everyone with a minimum standard of living, independent of employment status or history. In addition to the old-age pension, pillar one also comprises the ATP scheme that covers all earners in Denmark. Contributions to the ATP scheme is financed one-third by the employee and two-thirds by the employer (ATP). The premium is dependent on number of working hours and not the income level, and there is no guarantee that you will receive the same amount as you have contributed, it could be more or less. Danish citizens born after June 1955 will receive the social pension from the age of 67 until the rest of their life (Pensionsloven 2012) Occupational Pension Arrangements that are established in combination with employment are placed in the second pillar, often called labor market pension schemes. The occupational pension schemes are privately organized by mandatory contributions from employers and employees. This system provides additional pension payments to pillar 1, where the benefits received at retirement are related to employment status and history. It is a fully funded pension scheme where the contributions are invested in a fund to meet the future liabilities to policyholders. There are three types of labor market pension schemes; agreement based pension, company pension and public service pension (Andersen 2013, pp. 77). An agreement based scheme concerns a group of workers that belongs to the same sector or have the same education, independently of what company they work for. Company pension is based on agreements between an employer and a pension company, while public service pension accounts for employees in the state, local government and regions Personal Pension The third pillar in the Danish pension system is voluntary personal pension agreements that are fully funded. This can for instance be a product in a financial institution or an insurance product in an L&P company, where the contributions are entirely individual depending on policyholders personal needs and resources. The purpose of the personal pension is to receive higher benefits at retirement for those who can afford it, where the policyholder can influence investment decisions and thereby control some of the risk in the contract. The figure below will summarize the three-pillar system with its main characteristics, and how each pillar is organized. 5

11 Pillar I Pillar II Pillar III Statutory Poverty relief Tax funded Mandatory Labor related Privately organized Voluntary Flexibility in investments Privately organized Equal for all Unfunded Funded Funded DB DB DC DC Table 1: The Danish Pension System As can be seen from the figure above, a pension scheme can either be organized in a defined benefit scheme or a defined contribution scheme, which will explained in the next section. 2.2 Pensions Schemes One of the central questions when discussing L&P schemes is in what way contributions and benefits are organized. In Denmark, as can be seen from the figure above, there are two main schemes (System 2011) Defined Contribution A majority of the pension arrangements in Denmark today are defined contribution (DC) schemes (Andersen 2013, pp. 78). A DC scheme is fully funded, where contributions are predetermined while benefits are not known in advance. Benefits in a DC scheme are based on predetermined contributions from the employer, employee or both, normally as a fixed fraction of the income. The pension contributions will be invested and the depot will be credited the market return, so the benefits directly depends on the performance of the investments. Since the terminal value of the of the pension contract depends on market returns, the pension benefits at retirement could be more or less than initial contributions. In years of high market returns, the interest rate credited to policyholder s depot will be correspondingly high, while in the opposite case the return on contributions will be low or even negative. As a consequence, in a DC scheme policyholders carry all of the investments risk which makes it attractive seen from L&P companies point of view. Some DC schemes give policyholder the right to take an active role in the investment process where they can choose a part of their risk profile. This creates flexibility to policyholders since they can choose how much risk they want to include. However, when policyholders are given responsibility of investing their own money, it can lead to inefficient investments since many individuals are irrational and inconsistent when planning their financial future (Waring and Siegel 2007). In most DC schemes, the participants are responsible to save enough money to cover their own retirements; hence they will have to bear the burden of longevity risk. This is the risk of outliving ones money that includes living longer than the age that you have been saving for, and end up with 6

12 no money in the last retirement years. No one knows how long their life will be, so policyholders need to save enough to cover an extreme outer limit of life span, for example you need sufficient pension savings to the age of 105. On the other hand, if you save for a too high age there is a risk that you die before you have used all the benefits. A solution is to hedge this risk by investing in a life annuity, which gives the pensioner an annual amount from retirement until death. We have now explained the traditional pure DC scheme. In Denmark there also exist a modified DC scheme that includes interest rate guarantees to reduce policyholders investment risk (Andersen 2013, pp. 78). Here L&P companies have issued contracts where contributions are annually credited a minimum rate of return, i.e. the guaranteed interest rate Defined Benefit The other main pension scheme in Denmark is the defined benefit (DB) scheme, and may be organized as funded or unfunded; hence the DB scheme can be applied to pillar II and I (System 2011). In a DB scheme the benefits are determined in advance when entering the contract, and will normally be based on earnings, length of service and life expectancy. For example, policyholders get a fraction of final salary or a weighted average of previous earnings, at retirement. Contributions in a DB scheme are usually a fraction of employees wage, contributed by the employer, employee or both. To find the contributions sufficient to meet future claims, L&P companies needs to calculate the future benefit payments based on a formula including interest rate changes, life expectancy and retirement age Life expectancy is the expected numbers of years to live for people born in the same year. All contributions are invested in a pool of assets managed by skilled investors; hence diversification benefits arise. This way, L&P companies can systematically control how much investment risk they want in their portfolio. In contradiction to a DC scheme, L&P companies are the holders of investment risk in a DB scheme, since sponsors have guaranteed a benefit to each of the policyholders, for example 75% of their final salary. If the money falls short due to market fluctuations, L&P companies are legally responsible to take action to meet future obligations. In a DB scheme longevity risk is also essential, but as opposed to DC schemes L&P companies carry the risk. However, one of the main advantages by a DB scheme is that they can diversify this risk by pooling the clients assets. The insurance principle secures that the savings to people who die young remains in the pool and finances those who outlive their savings (Waring and Siegel 2007). This enables L&P companies to only focus on the life expectancy of the fund and not the extreme outer limits of age, which the DC scheme has to consider Payout Options We have now seen how contributions can be organized in a pension scheme, but the payout phase of the benefits are still not clarified. There are mainly three payout options offered in the Denmark (Pension). Capital pension is the first one, and is typically organized as a lump sum where the entire 7

13 pension savings is paid out as a single amount. The second is an annuity pension scheme, where a fixed income for a certain period after retirement is offered, for example 15 years. Life annuity is the third option, where benefits are distributed as a regular income for the rest of policyholders life, i.e. from retirement until death Demographic Challenges Danish L&P companies should always post sufficient provisions to cover future obligations to policyholders, e.g. an interest rate guarantee or a life annuity (Andersen 2013, pp. 231). However, for the last decades demographic changes have made it more difficult to fulfill these promises, mainly due to two reasons. The first reason is that people live longer, resulting in contributions which were sufficient years ago are no longer covering benefits for the entire lifetime (Barr and Diamond 2006). Secondly, there has been a trend of an earlier retirement age, which also increases the period policyholders should be covered by the pension savings. In a pay-as-you-go system, the combination of these trends has resulted in an increasing dependency ratio. The dependency ratio is defined as the ratio of dependents, which is people younger than 15 or older than 64, to the working-age population, which are between the age of In 2004 the dependency ratio was 50,96% while in 2011 it has increased to 53,19% (Economics 2012). The consequence of an increasing dependency ratio is a larger burden on the active population since a group of 100 workers need to finance a larger group of retirees. If the payout phase of a pension scheme is organized as a life annuity, these demographic challenges will increase the liabilities to L&P companies, since the period where policyholders are promised annual benefits is increased. 2.3 Danish Pension Products We have two main pension schemes, defined benefit and defined contribution, which can be combined with additional products. We would like to describe guarantees, bonus potential and the possibility to surrender, which have the characteristics of options Guarantees A guarantee is a formal insurance that certain conditions will be fulfilled. A guarantee should put policyholders in a better position than the position the policyholder originally have under the law (Markedsføringsloven 2012). When L&P companies have issued a guarantee, they have a legal obligation to meet the claims. Normally a guarantee has a predefined maturity where the issuer is not committed anymore. There are different guarantees issued by L&P companies, for example interest rate- and maturity guarantee. In Denmark, guarantees are normally connected to an average rate product (Andersen 2013, pp. 536). In an average rate product, policyholders depot will at the end of each period be credited an average rate that will smooth out the fluctuations in the market return. In this way, policyholder will 8

14 receive a more stable and predictable return on their pension savings, as opposed to if the depot should follow the actual return on the market, like in a pure DC scheme. In practice, this smoothed return on contributions consists of two elements, a guaranteed interest rate with an additional bonus on top through profit sharing. The bonus element will be explained in the next section. An interest rate guarantee gives a promise of a minimum credited return on policyholders contributions, even if the market return is below the guaranteed rate. By this, the interest rate guarantee will share the characteristics of a risk free bond, which repays the principal and interests with certainty. In an option view the interest rate guarantee is a long put option on the market interest rate seen from policyholders point of view. A long put option gives the holder of the contract the right, but not the obligation, to sell something back at a predetermined price to the holder of the option. By this we mean that the guarantee gives the policyholder the right to receive a return that is at least equal to a strike price, which is the guaranteed interest rate. If the market return is above the strike price, the option is out-of-the-money for the policyholder. On the other hand, if the market interest rate falls below the strike price, the option contract is in-the-money. In this scenario, L&P companies are obligated to cover the difference between the market return and the interest rate guarantee at maturity. In a pure DC scheme, policyholders hold all investment risk and have a variable terminal value. So when interest rate guarantees are embedded in DC schemes, some of the investment risk is transferred from policyholders to L&P companies. Another type of a pension guarantee is a maturity guarantee. A maturity guarantee is a promise to repay some absolute amount at maturity, for example 75 % of initial deposits (Grosen and Jørgensen 2000). This is closely related to how the benefits in the DB scheme are determined, since the guaranteed benefit becomes a liability to L&P companies Bonus Potential In addition to the interest rate guarantee, the Danish average rate product includes a bonus element, which corresponds to policyholder s right to receive a share of L&P companies return that exceeds the guaranteed rate (Grosen and Jørgensen 2000). In opposite to the guaranteed return, the bonus potential is conditional on the profit to a company. Thus only in the case where the return on pension companies investments exceeds the guaranteed interest rate, some of the profit can be distributed to policyholders accounts through bonuses. However, if the return on investments is less than the guaranteed interest rate, there will be no bonuses and L&P companies have to cover the deficits. The main source is the collective bonus potential that is accumulated during good periods, and used when investments underperform. Although policyholders have a right to take part of the profit in an average rate product, L&P companies have an option to choose how much bonus to share with their policyholders; they can either choose an aggressive or conservative bonus policy. If an L&P company is conservative, they share a small fraction of their profits with policyholders and hold a larger fraction as buffer in the 9

15 company to protect itself against periods with underperformance. On the other hand, with an aggressive bonus policy the firms pay high bonuses and hold less as buffer. The bonus potential can also be looked at in an option view, where policyholders have a long call option on the assets of L&P companies where the strike price is equal to the interest rate guarantee. A call option is the right, but not an obligation, to buy something at a predetermined price at a given maturity. When the value of the return on investments is above the interest rate guarantee, the call option will be in-the-money, and policyholders receive a fraction of the profits, depending on the bonus policy of L&P companies. When the return is below the interest rate guarantee, the bonus option is out-of-the-money while the interest rate guarantee comes into-the-money, ensuring a minimum credited rate to the depot Surrender Option Another product that can be combined with the two former, is a surrender option (Grosen and Jørgensen 2000). A surrender option is policyholders right to end the contract at any point in time before retirement, and receive a surrender value equal to the depot. This American option becomes valuable when the market interest rate exceeds the guaranteed interest rate, since then policyholders could receive a higher return investing the money in the market. When market interest rates falls below the interest rate guarantee, rational policyholders will not surrender from the contract. When these three products are combined in a pension contract, the contract is protected against declining interest rates by the interest rate guarantee, while the surrender option becomes valuable when the market rate exceeds the guaranteed rate. The bonus option comes in-the-money when the market rate increases above the guaranteed rate, hence the surrender option is most valuable for the policyholder when L&P companies have a conservative bonus policy. 2.4 Pension Contracts To summaries this passage we will introduce four different contracts that differs in the risk exposure and options included (Grosen 2005). They are shown in the figure below. Risk exposure on policyholders Risk exposure on L&P companies Unit linked products Unit linked products with guarantee Profit sharing contracts with embedded guarantee Guaranteed investment contracts Figure 1: Pension contracts by risk exposure At the one extremity we find the unit linked products, which is a product within the pure DC scheme. Here the participants are fully exposed of the investment risk since the value of the contract is directly connected to market return. The unit link products can be combined with an interest rate 10

16 guarantee, to transfer some of the investment risk from policyholders to L&P companies; the higher guarantee, the less risk is borne by policyholders. Hence, we move to the right in the figure above. At the other extremity we have the guaranteed investment contracts. Here L&P companies are fully exposed to investment risk because of embedded guarantees, as in a DB scheme. Also here, a higher guarantee gives a higher exposure to risk. If we move to the left in the figure above, we find the profit sharing contracts with embedded interest rate guarantees, also called participating contracts. They have the value of the interest rate guarantee as a floor, as in the unit linked contract with guarantees, but the participating contract has a bonus option on top that gives participation in the profit of the L&P company. We have illustrated the payoff structure below of this participating contract: Option value Bonus option Risk free bond r G Market return Figure 2: European participating contract We have now seen that L&P contracts can be decomposed into different option elements, which shown in the table below. Participating American Contract Value Risk Free Bond Bonus Option Surrender Option Participating European Contract Value Table 2: Option elements of a pension contract Seen from the table above, the traditional European participating contract includes an interest rate guarantee and a bonus option. In addition, a surrender option could be included making it an American participating contract. This contract then consists of two option elements on top of the 11

17 risk free bond, which makes this contract more valuable than the European counterpart, with a value equal to the surrender option. An L&P contract with embedded surrender option, bonus option and interest rate guarantee gives policyholders the best of all worlds. In this participating contract they are protected on the downside by the risk free bond imposed by the interest rate guarantee, and have the ability to surrender the contract if better terms are available. In addition they have the right to participate in the profit of L&P companies, if the market performs well. This is an example of an extremely lucrative pension product seen from the policyholder s point of view. However, these products have led to high investment risk and solvency problems for L&P companies, where the origin to the problems will be explained in the next section. 12

18 3.0 The Crisis in the Danish L&P Sector The difficulties in the Danish L&P companies have its origin from the early 1980s (Grosen 2005). Here the market interest rates were as high as 20%, and L&P companies started to issue high interest rate guarantees as a competitive weapon towards other companies. These guarantees were as high as 4,5%, but due to the high interest rate environment they were nearly worthless to L&P companies and policyholders. After the peak in Danish long-term bond yields in 1982, a period of declining market interest rates followed. Below a figure from (Economics) have been copied, showing the continuous declining interest rates from the beginning of the 1980 s until present time. Figure 3: Declining interest rate on Danish 10Y government bonds since the 1980's This resulted in a narrowing of the margin between the guaranteed interest rate and the market interest rate, and made policyholders guarantees to move from far out-of-the-money to become inthe-money. If the decline in interest rates was temporary, L&P companies buffers could have absorbed the losses. However, interest rates continued to fall, which gave L&P companies problems of meeting their long-term financial obligations to their policyholders. Despite the development of the market interest rate, the regulatory authorities and the L&P sector did not react until 1994, when the maximum guaranteed interest rate on new issued contracts was lowered to 2.5% (Ladekarl, Ladekarl et al. 2007). In 1999 and in 2011 it was lowered again to respectively 1.5% and 0.5%. A reason for the late reaction to declining interest rates was that pension companies enjoyed an increased excess return on equities, due to the stock market boom of the 1990s. At the end of the 1990s the sector was extremely vulnerable negative changes in the stock market, as a result of increased positions during good times, and further declines in interest rates. 13

19 The climate of the stock market changed dramatically in 2001, especially in the wake of the events of September 11. This led to falling stock prices and turned total investments negative. L&P companies reacted by decreasing their investments in equity, and suffered large losses. Although the market experienced an increase in stock prices after 2003, L&P companies only derived limited benefit from it since they had reduced their positions. After the Global Financial Crisis of , the market has suffered from low asset returns in addition to low interest rates, and in 2012 the interest rate fell sharply as a result of the debt crisis in Europe, leading to a decreasing funding ratio in Danish L&P companies. Funding ratio is defined as the ratio of an insurer- or pension companies assets to its liabilities (Investorwords), where a funding ratio below 1 means that L&P companies are unable to meet their payments or are in jeopardy of not being able to make their payments at a later point in time. The declining funding ratios endangered the whole L&P sector. The stock market downturns in 2001 and 2007 finally disclosed the underlying problem of high interest rate risk in the balance sheet hidden by high equity returns in the 90 s. The combination of declining market interest rate and the stock market downturn, gave L&P companies solvency problems since the value of the assets could not cover their liabilities. Denmark still operates in a low interest rate environment, as can be seen in figure (3) above, and the solvency problems are still present. In addition to market developments described above, the L&P sector was also exposed to new- and changed regulations by the government, which made the situation even worse. In the following section, we will shortly explain some of the regulations relevant for the L&P sector. 14

20 4.0 Accounting Standards and Regulation The main international regulations for L&P companies in Denmark are the International Accounting Standards, International Financial Reporting Standards and the Solvency rules. After explaining these regulations, an introduction to the Danish Stress Test and the new liability side of Danish L&P companies will be presented. 4.1 An Overview of International Financial Reporting Standards The international accounting standards (IAS) have been issued by the Board of International Accounting Standard Committee (IASC) since 1973 (Deloitte). At the 1 st of April 2001, the new International Accounting Standard Board (IASB) replaced IASC and took over the responsibility of issuing the new International Financial Reporting Standards (IFRS), in addition to adopting the existing IAS regulation. Businesses are constantly expanding across borders and an increasing number of multinational companies are established. So the objective of IFRS is to develop a single set of global accounting standards, which is comparable and consistent across borders and companies. The financial statement should reflect fair-, relevant- and reliable values of the financial position of the firm, making the balance sheet more transparent for internal and external parties. In June 2002 the European Union (EU) adopted the rules which required companies to develop their consolidated financial statements in accordance with IFRS from 2005 and onwards (Deloitte 2013). As a member state of the EU, Denmark is obligated to prepare their financial report and the basis of presentation according to the European IAS regulation. Next we would like to introduce different standards that concern the L&P sector in Denmark, which are IAS 19 and 39 and IFRS 4, 9 and 13 (Deloitte 2013). Introduction to the standards are not exhaustive and written as guidance to understand the basic of the standards IAS 19 Employee Benefits IAS 19 concerns employer benefits and was first issued in 1998, and then revised with efficient date from January The objectives of this standard are to identify and determine the accounting requirements of employer benefits, and how these benefits should be measured. Employee benefits are defined by Deloitte as all forms of consideration given by an entity in exchange for service rendered by employees. Relevant for L&P companies is the reporting of employee benefit obligations and employer-sponsored DB schemes. IAS 19 should capture all changes in employee benefits and report them at fair value, which will reveal the true risk profile of L&P companies and have a large impact on DB schemes and DC schemes with guarantees. 15

21 4.1.2 IAS 39 - Financial Instruments: Recognition and Measurement IAS 39 concerns the classification and measurement of financial instruments, and was first issued in 1984 and reissued in 2003 with application from IAS 39 is to be replaced by IFRS 9 of financial instruments for annual periods in the beginning of IAS 39 addresses recognition and measurement of financial assets and liabilities, and contracts to buy or sell non-financial items. However, this standard does not account for equities. The financial instruments are reported at fair value or when not available, at amortized cost. IAS 39 defines fair value as the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction. A fair value hierarchy is used to determine the valuation techniques used to estimate fair values, which will be further explained in IFRS 13. Products relevant for a pension contract covered by this standard are fair valuation of financial liabilities, embedded options and instrument used for hedging purposes IFRS 4 Insurance Contracts IFRS 4 concerns insurance contracts and was issued in March 2004 and applies to periods from 2005 and onwards. The objectives of the standard are increased comparability among insurance firms on a global level, as well as a more sound and transparent system. IFRS 4 applies to insurance- and reinsurance contracts, where Deloitte defines insurance contract as a contract under which one party (the insurer) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder if a specified uncertain future event (the insured event) adversely affects the policyholder.". The standard was implemented for the improvement of the practices concerning disclosure for all insurance contracts issued, and for all reinsurance contracts as well as recognition and measurement IFRS 13 - Fair Value Measurement IFRS 13 was issued in 2011 and applies to from IFRS 13 introduces a fair value hierarchy to choose the correct valuation technique in order to find the fair value of an instrument. The objective of the hierarchy is to improve the consistency and comparability among firms, and increase the transparency of the fair valuation. This hierarchy is divided into three levels: Level 1 estimates are the most preferred inputs for fair valuation, and are quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date (Deloitte). 16

22 Level 2 estimates take into account the fact that finding active markets for identical assets and liabilities can be challenging. The estimates from Level 2 will then be inputs other than quoted market prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. (Deloitte). In practice this means that fair valuation can be based on quoted prices from similar assets or liabilities in active markets, or quoted prices for identical or similar assets or liabilities from non-active markets. Level 3 estimates are used when the two others are not possible to obtain. IFRS 13 describes them as unobservable inputs for the asset or liability, used in situations in which there is little or no observable market. Here valuation techniques are used to find fair value estimates, and use the best market inputs available. Hence, level 3 estimates will vary a lot among companies, so it is important that the valuation techniques are consistent to provide useful information of fair values. 4.2 Solvency II In 2002 Solvency I was introduced, but was expected to be replaced by Solvency II the 1 st of January 2014 in EU countries, in addition to Norway, Lichtenstein and Iceland, but is now postponed to January 2016 at the earliest (Deloitte 2013). It is the Danish FSA's intention that the changes will come into effect from 1 st of January 2014 in Denmark, and L&P companies have come a long way on implementing the new Solvency framework. This is the reason why we would only focus on the Solvency II framework. Pension companies are originally not covered by the Solvency II regulation since the rules for pension companies are very country specific that varies significantly across countries, but in Denmark, Danish pension funds are subject to the new Solvency rules (Pension 2012). The Solvency II framework requires regulated countries to incorporate the EU legislation into national law. The main objectives are to harmonize the insurance regulation in the member countries and enhance consumer protection. The regulations aim to achieve higher risk awareness and improve the consistency of the valuation process, by including marked-to market valuation of the balance sheet (Lloyd's 2010). Three pillars build up the solvency framework, and each pillar will shortly be explained below Pillar I The first pillar covers quantitative requirements, concerning the capital requirements. L&P companies need to hold enough resources to cover both the minimum capital requirement (MCR) and solvency capital requirement (SCR). The capital requirements impose a buffer on L&P companies, so they are able to meet policyholders obligations in times of market stress. (Deloitte). SCR reflects the level of capital that enables L&P companies to absorb unforeseen losses. There exists a standard formula sat by regulators to calculate the SCR, or the company can develop an internal model. In the standard model, the SCR is the value-at-risk (VAR) which gives the worst unexpected loss under normal conditions over a 1 year horizon at a 99,5% confidence 17

23 level(commission). The internal model incorporates the specific risks L&P companies are exposed to and at the same time consider risk mitigation techniques. If they do not hold enough capital to satisfy the SCR, the level of supervisory intervention increases until the SCR is fulfilled. By the SCR, poor performance of L&P companies is identified before it becomes a threat to policyholders. If, in despite of the supervisory intervention, the resources continue to fall, MCR represent the lowest possible solvency level. If L&P companies buffers fall below this level, policyholders would be exposed to an unacceptable level of risk if L&P companies continued their operations. Then the ultimate supervisory action will be activated, where L&P companies will be handed over to a third party or be liquidated. These capital requirements are based on the values in the balance sheet, where all assets and liabilities need to be marked- to market values, according to the IFRS framework Pillar II The second pillar concerns qualitative requirements (Lloyd's 2010). It has two objectives, the first is to ensure that the firm operates well and meet the risk management standards. This will encourage L&P companies to invest in an enterprise risk management system which will identify, measure and monitor specific risks of companies. The second objective is to constant monitor that the firm is sufficiently capitalized, and if not, ensure that the company reaches the level of the SCR before the supervisory authority intervenes. In addition the senior management of the company has to review the risk of the firm and ensure to hold enough capital to meet these specific risk factors Pillar III The third pillar concerns market discipline, more specifically reporting and disclosure requirements. The former requires L&P companies to deliver relevant and verifiable information in their reports to enhance the transparency, and disclose necessary information to relevant stakeholders. In the new Solvency framework, it is recognized that the qualitative requirements are as important as the quantitative. To check the quantitative requirements there can be used a stress test. Denmark has developed a stress test called the traffic light system, which test if solvency requirements are fulfilled in two different market scenarios. 4.3 The Traffic Light System FSA invented a new way to test the solvency positions and capital requirements of Danish L&P companies (Ladekarl, Ladekarl et al. 2007). In 2001 they introduced a stress test, called a traffic light system. The system came as a response to the increased stock investments by L&P companies, used to compensate for falling interest rates. The traffic light system requires Danish L&P companies to report the impact on capital reserves and future pension obligations in two different market scenarios, where a minimum solvency of the firm 18

24 must be maintained. In the system, market risk is incorporated through simultaneous changes in the interest rate, stock- and real estate prices. The first moderate scenario is called a red light alert system, and gives highest consequences if failed. Here stock prices falls by 12 % while the interest rate changes by 70 basis points and real estate prices decreases by 8 % (Jørgensen 2004). If the L&P company is not able to meet the minimum solvency requirements, the FSA will impose more frequent solvency reports, as each month, and could force higher capital requirements. In the strictest scenario, L&P companies receive a yellow light from the FSA. Here the stock prices fall by 30 %, the interest rate changes by 100 basis points and the real estate prices falls by 12 %. L&P companies receiving a yellow light from the authorities will be asked for quarterly solvency reports and could risk higher capital requirements. If Danish L&P companies manage to pass both of the scenarios, they receive a green light from the FSA, and have a solid financial position. In 2008, an agreement between the Ministry of Business and Growth and the Danish Insurance Association was made to protect Danish policyholders from the latest events in the financial market (Vækstministeriet 2008). It was decided to no longer use the yellow light scenario and instead place a higher focus on the Solvency rules. When the strictest scenario is removed, L&P companies will not as fast fail and come under the FSA s control with increased capital requirements. The last regulation to mention, came in 2002, and covered the decomposition of the liability side in L&P companies.. The new liability side of the balance sheet will be explained below. 4.4 The New Liability Side Until 2002 the liability side in L&P companies consisted of equity, bonus smoothing reserves and the technical provision, corresponding to the value of the future pension obligations. In 2002 a decomposition was proposed to make the balance sheet more transparent, by splitting the technical provision into guaranteed benefits and bonus potential on future- and paid-up premiums (Jørgensen 2004). The comparison of the old and the new liability side are shown in the figure below. 19