The report, Fixed income strategies of insurance companies and pension funds, examines the effects of Solvency II and IFRS* on the asset allocation of insurance companies and pension funds and the resulting impact on financial markets.
Mark Carney, Chairman, Committee on the Global Financial System at the BIS, said introducing the report, “Over the coming years, accounting and regulatory changes could lead to reallocations of funding across financial instruments and sectors and encourage greater use of derivatives.”
“The changes could also make it more difficult for insurance companies and pension funds to play their traditional role as global providers of long-term risk capital and accelerate the shifting of risks to households,” he added.
The report said that the overall effect of accounting and regulatory changes is likely to be a reallocation of assets to reduce risk. “The proposed changes tend to make it more expensive to hold equity-like instruments, structured products, and long-term or low-rated corporate bonds, whereas government bonds and covered bonds will receive relatively favourable capital treatment.”
Faced with higher capital charges on riskier assets, insurers have a number of options:
- Change size and asset allocation portfolio.
- Transfer risk to financial markets through reinsurance, securitisation of use of derivatives.
- Restructure or streamline group operations.
- Redesign products over time by reducing guarantees and options.
On balance, the authors of the report believe asset allocation will be the most commonly used path but warned of a number of systemic implication this may have.
Shifting risks to households
The damage caused by the financial crisis and continued adverse microeconomic conditions together with the proposed accounting and regulatory changes are putting pressure on the asset side of the balance sheet of insurance companies and pension funds. One possible implication could be an adverse effect on consumers.
“These factors combined make it more difficult or costly to honour guaranteed returns or defined benefit obligations,” the report stated. “Life insurance companies and pension funds are thus likely to continue changing the characteristics of the products they offer with a view to repricing or reducing their exposure to risk stemming from the liability side of their balance sheets.”
This shift of a portion of the risk to households could result in “inefficient risk-sharing” which in turn could have a negative wealth effect that could reinforce a downturn.
“When fully exposed to market risk, individuals may opt for pension plans or insurance policies with lower risk allocations, or choose to build their own retirement savings by holding relatively safe mutual funds or bank deposits. Such products may not offer sufficient expected return to ensure adequate retirement income without additional saving.”
Although these effects may vary between countries, this takes away from the essential function of risk-pooling preformed by insurance companies and pension funds.
* Other factors are also considered but Solvency II and IFRS were considered the most significant.
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