03 July 2009

Published in: Corporate strategy, Risk governance, Investment risk

Insurers should take a fresh look at their own pension funds

UK Insurers that operate defined benefit pensions can reduce the cost of their regulatory capital if they take a more holistic view, says Yasheen Rajan.

UK insurers that operate defined benefit pension schemes on behalf of their employees will find themselves with a further competing mouth for their already scarce capital resources. But, by coordinating their own risk management with that of their employees' pension fund, insurers can identify risk concentrations and encourage the use of diversification and risk control strategies to reduce their combined Individual Capital Assessments (ICA), the Financial Services Authority's framework for setting insurers' regulatory capital.

The design of the ICA requires insurers to go a step further than their corporate counterparts in the context of in-house defined benefit schemes. In addition to recognizing balance sheet deficits, a pension fund's activities must be risk charged and aggregated with the insurer's capital requirements. The ICA essentially views a pension fund as a risk bearing entity of the insurance group and treats it accordingly.

But, while insurers have the risk management capability to control most of their own risks, their pension funds' risks are less easily influenced. Trustees covet their independence and typically do not retain the same level of actuarial and investment expertise as their insurance sponsors. As a result, risk mitigation decisions are often implemented slowly, if at all: when markets crash, trustees' first thoughts are to return the portfolio to benchmark weightings rather than de-risking in line with the insurer -- consuming the insurer's risk capital at a time it is needed the most.

In addition to accounting for any deficits, most insurers find themselves with a fairly high ICA charge for their pension fund. Supported by the sponsor covenant, pension funds tend to have risk-intensive strategies, and in many cases, their risks are highly correlated with their insurance sponsors.

Many insurers and their corporate strategies continue to be dogged by their pension funds, suggesting most are yet to fully address the risk interaction. Moreover, the situation as it stands does little to help insurers who are trying to become efficient as to how they use their risk capital.

Therefore, a new approach is needed to address the risk interplay between pension fund and its insurance sponsor.

Risk co-ordination

Rather than continuing to act as completely separate entities, both the insurer and the pension fund now have an incentive to regard their activities and risks as inextricably linked.

For the insurer, greater co-ordination of risk-bearing activities will reduce the ability of the pension fund to deplete capital during market downturns. A holistic view of the pension fund and insurer could, at the simplest level, highlight concentrations in equity risk, encouraging the use of diversification strategies or simple derivatives to reduce the combined ICA.

For pension funds, the ICA itself provides the impetus and means to better meet members' obligations. By adopting a sophisticated risk culture and risk budgeting approach that characterizes the ICA, pension funds will be better equipped to identify undesirable or unrewarding risks.

This will encourage smarter and more capital efficient investment strategies to be adopted, which in turn help the pension fund to achieve its return objectives with greater certainty. This also has the added benefit of strengthening the sponsor covenant.

The challenge becomes one of recognizing and managing the interaction between the activities of the two parties. Achieving the right balance between the insurers' goals and that of its pension fund means:

• The quantification of a risk budget that can be afforded by the insurer's capital position, formulated in ICA amounts, and a framework for updating this risk budget.
• The adoption of this risk budget by the trustees and continual monitoring and management of the scheme's risk position relative to the budget and the insurer's evolving profile.
• The quantification of the risks in the insurer's book of business and the scheme's and how they relate and overlap.
• Identifying which of these risks to manage and which to eliminate as the profile evolves, and the associated mechanism.
• The development an optimal funding schedule and structure that relates to both the insurer and pension fund's solvency position.
• Taking advantage of best investment and capital markets solutions available to help manage the pension fund's investment strategy and the aggregate risk exposure.
• The development of a total plan for the pension fund, so that a long-term objective can be met and as the pension fund approaches this position, the risk budget and profile evolve.
• A reduction in the amount of management time taken up with the pension fund by making the outcomes more predictable.

Not without challenges

This new approach presents challenges for both the insurer and trustee directors.

First, the quantification of risk appetites and budgets tends to be a nebulous concept for some insurers, even more so in the context of in-house pension funds. The issue becomes multi-dimensional as risk budgets will influence the investment strategy and therefore the contribution schedule.

Secondly, trustees typically lack an in-depth understanding of the ICA framework and the benefits that it affords. In addition, the implementation of an investment strategy that optimizes a given risk budget necessitates that trustees become investment and ICA capital modelling experts, able to understand combine a wide array of assets and strategies to deliberately meet the return target.

Thirdly, the collation of risks across the group requires multiple parties to be coordinated from the various management committees through to actuarial functions and consultants. This will require some risks to be managed by those with specialist risk transfer experience, more typically found in capital markets outfits than insurance companies.

Governance solution

The solution to many of these issues lies in the sophistication of the governance activity. An effective governance structure is one that provides a control environment for investments by focussing on what is most important for the business. For example, it is more important that the trustees understand the effects of a duration hedge on the pension fund's solvency and insurer's ICA, rather than the mechanics of the duration hedge itself.

By changing the focus of the governance structure to one that is more meaningful for the management teams of the two parties, the insurer could make a more quantitative assessment of its risk appetite with regards to its pension fund. And a more sophisticated set of solutions could be applied in the pension fund, avoiding the resourcing constraints and trustee heuristics that often inhibit implementation.

Insurers and pension fund trustees may need expert help to implement such a project -- not least because getting it wrong can be costly. With the right assistance, they can:

• Develop a capital-centric governance structure and control environment for investment risk.
• Understand how best to drive the risk aggregation process, translating amalgamated risk classes into meaningful outputs that can be analyzed and used by the governance structure.
• Structure and execute applicable hedging solutions across the range of risk classes.
• Educate the pension fund's trustees about the specifics and benefits of ICA.
• Provide the trustees with an in-house investment management capability that marries ICA-efficient strategies with pension fund specific solutions.
• Incorporate advanced capital modelling and actuarial skill-sets to understand how best to combine different asset classes and strategies in the context of the ICA.
• Provide long-term solutions for the pension fund, from advanced corporate finance solutions involving contingent assets through to a buy-out of the liabilities.

Yasheen Rajan is a partner at Utility Capital Management, currently advising Royal Liver Assurance on its defined benefit scheme. hello@utilitycm.co.uk

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