The current financial crisis is having a major impact on pension funds, with only a small number of these now able to retain their full risk capacity. Many boards are debating how to improve their risk capacity and thus secure the entitlements of active insureds and pensioners. One measure under discussion to reduce risk is to adjust the investment strategy. In major cases of underfunding, there is also the option of raising special contributions.
Unfortunately, adjusting the investment strategy to reduce risk would limit potential returns when the capital markets recover, and imposing supplementary contributions for employers and insureds would only add to their burdens at this difficult time. However, by transferring more biometric risks to an insurance company, it is possible to improve the balance sheet structure of pension funds and thus their risk capacity, without resorting to more radical measures.

Biometric risks of pension funds

In securing insured benefits for old age, death and disability, pension funds take on biometric risks. Whereas death and disability risks generally fluctuate annually, there is a steadily upward trend towards longer benefit payments to pensioners. Both the fluctuation risks of death and disability, as well as increased life expectancy, affect pension funds through the need to build reserves. Since these reserves must have the same coverage ratio for active insureds as for pensioners, they absorb funds that thus become unavailable for other purposes.

The level of reserves for death and disability risks are generally set in line with expected claims; reserves to compensate longevity are set in relation to the available reserves of the pensioners portfolio. If a pension fund reinsures part of its insured risk, often in the form of a stop loss insurance, the reserve for the fluctuation risks of death and disability is only required to cover the fund’s risk retention.

Transferring biometric risks

There are several ways to transfer the biometric risks of death and disability to an insurance company, with flexibility on whether the risk transfer should be partial (up to a defined self retention), or full. Partial transfer means that there can be a smaller risk fluctuation reserve in the pension fund. The full transfer of risks removes the need to keep any risk fluctuation reserve at all.

While the transfer of longevity risks may be unattractive to many pension funds on cost grounds, transferring the pensioner portfolio can lead to an improved balance sheet. By simply transferring new pensioners, the fund can stabilise its future obligations by avoiding the trend towards ever-increasing average lengths of pension payments.

By fully reinsuring the biometric risks, the burden removed from the liabilities can be used to increase the securities fluctuation reserve. Once this has reached the required level, any remaining reserves can be allocated as free asset reserves. In this way, the structure of the pension fund’s balance sheet can be substantially improved, for example, by rebuilding risk capacity for investments. This can also help avoid the need to raise additional contributions.

Naturally, by transferring biometric risks to insurance companies, in comparison to autonomously managing the risk process, there are opportunity costs that can be as high as the costs of equivalent insurance contributions. However, when there is poor claims experience, the inclusion of a large insurance company in the process allows better calculation of the load on the pension fund. In addition, a higher transfer of biometric risks is only necessary for as long as it takes to secure the solvency of the pension fund.

The insurance company taking on the risks will generally ensure that it receives an adequate price to cover the liabilities involved (based on prior claims experience). If there are major positive deviations between expected and actual claims, the use of claims experience systems can substantially reduce the net costs for the pension fund.