In a financial crisis stock prices usually decrease due to financial setbacks in companies in general. In order to kick-start the economy, central banks typically lower the interest rates, which lead to a problem of reinvesting for the pension funds. The crisis therefore has an effect on both the stock and bond portfolios of the pension funds. Another problem with lowered interest rates lies in the technical provisions. When the technical provi-sions are discounted using a lowered interest rate, the present value of the provisions rise. This forces the pension funds to set aside additional capital in order to be able to meet their future obligations. Consequently a financial crisis is a great challenge for the pension funds’ ability to live up to their guarantees. In order to ensure that the pension funds do not become insolvent they need a buffer consisting of Equity, “Collec-tive bonus potential” and “Bonus potential on paid-up premiums”. This buffer can be used when the value of the technical provisions increases and the value of the total investments decrease. Thus it is important that the buf-fer is large enough to be able to cope with fluctuations in the financial markets. Furthermore the pension funds must ensure that the duration of the assets match that of the liabilities. This match could be accomplished with long bonds, except there is a scarcity of these and in general they are not long enough. Instead the pension funds must resort to interest rate derivatives. Swaps are the most commonly used derivative, however swaptions and CMS Floors are also widely used. The difficulties with fulfilling the pension guarantees have not gone unnoticed for the government. Hence they have made an effort to try to regulate the pension industry so that the members do not risk losing their entire life’s savings due to insolvency in pension funds. Consequently they introduced the use of market-consistent valuation of both the assets and the liabilities. This has elucidated the risk of interest rate volatility for the pension funds and made them able to take this matter into account to a greater extent. The official stress test, “the traffic light” is another example of recent regulation. Its purpose is to make sure that pension funds can stand up to even a quite radical change in the financial markets. Since its launch in 2001 the number of pension funds in the so-called red or yellow light, have diminished dramatically. In 2012 Solvency II is projected to commence. Solvency II is the proposed new EU legislation which will govern the capital requirements of insurance companies. Furthermore supervisory activities, reporting and public dis-closure of financial and other information are a part of the framework. One of the major influences Solvency II will have on the Danish pension funds is the much more severe risk scenarios that are involved in the stress test. Pension funds have in many occasions built their own risk management models. Especially VaR models have be-come popular in the recent years. Since VaR measures will be a part of the Solvency II framework this imple-mentation can be seen as a wise step in the direction of self-governance. Another way of managing the risk, that has been suggested, has been to estimate provisions using an option based model, thus forcing the pension funds to set aside more capital and therefore be less sensitive towards fluctuations in the market. Finally pension funds can construct a multi stage scenario model. Such a model can be very complex; however it gives the pension fund a new insight into their exposure to specific categories of risk. When dealing with all kinds of models, it is important to realize that they are not infallible. The value of any giv-en model is no better than the value of the parameters fed into the model. Therefore every model should be scrutinized regularly.
|Educations||MSc in Finance and Accounting, (Graduate Programme) Final Thesis|
|Number of pages||145|