Finanstilsynet recommends changes to product legislation for life insurers

Life insurers have in recent years had little capacity to retain risky investments with higher expected return over time. The introduction of tighter solvency requirements under Solvency II could intensify the short-term focus of life insurers’ asset management.

• Impact studies for Solvency II and Finanstilsynet’s stress test in light of the 2010 results show that a number of Norwegian life insurers currently lack sufficient buffer capital to meet the requirements entailed by Solvency II. Steps need to be taken to enable the build-up of larger buffers and to make it attractive for insurers and their policyholders to build up such buffers in the next two years before Solvency II is introduced, says Finanstilsynet’s Director General Bjørn Skogstad Aamo.

Finanstilsynet considers that the changes recommended in the product legislation will benefit policyholders by facilitating higher expected return. They will also simplify the legislation and draw a clearer distinction between risk borne by the policyholder and risk borne by the insurer.

New flexible buffer fund proposed

After considering a range of adjustments, Finanstilsynet recommends changes in the legislation governing the build-up and use of buffer funds. The existing rules require insurers to maintain various buffer funds with approximately the same function but with differing rules governing their build-up and application and also transfer values. Finanstilsynet recommends combining supplementary provisions and fluctuation reserves in a new, expanded buffer fund in order to simplify the legislation and strengthen insurers’ risk-absorbing capacity.

Finanstilsynet recommends an obligation to allocate excess return to the buffer fund up to a level equivalent to 10 per cent of premium reserves, combined with an obligation to transfer assets to the policyholder with final effect once the buffer fund exceeds 15 per cent. The buffer fund should be customer-specific and accompany the customer in its entirety upon transfer. The buffer fund should be available to cover negative return.

In Finanstilsynet’s view its recommendation concerning buffer funds should apply to occupational retirement pensions and paid up policies.

• Paid up policies pose the greatest solvency challenges with regard to the introduction of Solvency II. Finding a more robust solution for paid up policies will also reduce insurers’ risk related to premium paying contracts which potentially could become paid up policies, says Mr Skogstad Aamo.

Finanstilsynet has thus far not proposed concrete changes to the portfolio of prior individual products – contracts established prior to 2008 – but this may be considered.

The proposal for a new buffer fund may encourage higher buffers better able to absorb short-term fluctuations, thereby providing greater leeway for long-term asset management. This will benefit policyholders in the form of higher expected return.

Finanstilsynet also believes that an opportunity should be given to increase provisions for buffer capital in the years up to the introduction of Solvency II by widening the scope for individual step-up of supplementary provisions from as early as 2011.

End guarantee

The proposal for buffer funds is premised on the setting aside of accumulated excess return. After an overall evaluation Finanstilsynet decided not to recommend an end guarantee, or reversible allocations, whereby expected future excess return can also be employed to cover loss. Introducing an end guarantee raises issues both in relation to policyholders’ right of transfer and in relation to the constitutional protection of established rights.

Under Solvency II, expected future excess return will be determined by the difference between the risk-free market interest rate and the rate guaranteed in contracts. Any buffer based on expected future return will therefore depend on the interest rate level, and will be eliminated if the level of long rates falls to a level approaching the guaranteed rate.

An end guarantee could encourage insurers to take larger risks in the contract period. However, a buffer based on an end guarantee will be less robust than a buffer fund comprising previous excess return. In a situation where plunging stock markets are combined with a significant fall in long rates, as was the case in autumn 2008, a company's buffer based on expected future excess return will no longer be available.

Based on an overall evaluation, Finanstilsynet considers an end-guarantee model to be less appropriate both for policyholders and the insurer than an arrangement involving a flexible buffer fund.

Voluntary conversion to unit-linked pension rights certificates

Finanstilsynet recommends allowing policyholders to voluntarily convert paid up policies and unit-linked pension rights certificates. This could help to reduce insurers' market risk at the same time as pension policyholders are given greater flexibility in terms of investing their funds and therefore the opportunity to invest in assets offering higher expected return.

This recommendation should probably only apply to retirement pension benefits. A closer look is needed at some aspects of voluntary conversion of paid up policies and prior individual products. Finanstilsynet aims to present a complete recommendation with regard to the transposition of Solvency II into Norwegian legislation in summer 2011.