Building a healthy pension system


As pension systems in the European Union are put under strain by growing deficits and demographic pressures, the need for savings only grows stronger.

The proposal by the European Insurance and Occupational Pensions Authority (EIOPA) for the creation of a pan-European pension program aims at meeting the European consumers’ increased demand for savings with an eye to complementing their future retirement incomes.

Dimitris Zafeiris, head of the Risks and Financial Stability Department at EIOPA, discussed the issue with Kathimerini on the sidelines of a recent conference on the management of insurance fund reserves, organized by Piraeus Asset Management MFMC.

How would you describe the private pensions and occupational sector in Europe? What are the main challenges and trends?

One of the imminent challenges debated in international economic fora is to provide for sustainable pensions in Europe and globally. The European Commission has rightly identified vulnerabilities in the national pension provisions in light of fundamental changes and undeniable trends in demographics and labor markets.

Europe’s diverse pension systems are tested for sustainability in times of unconventional career paths, mobility, digitalization and a highly demanding economic environment for the financial sectors. Most member-states have in common a need for citizens to save more for an adequate retirement income in the future – also due to underdeveloped or non-existent occupational pension funds – and the need to strengthen the financial markets.

Defined benefit (DB) funds are increasingly underfunded and have been notorious when assessing the impact of corporate failures on employees. The shift from defined benefit (DB) to defined contribution (DC), shifting the investment –  and often longevity – risks to the members and beneficiaries, releases pressure from the DB guarantors, but sets out new conflicts of interest, often at the disadvantage of the consumers.

In a number of member-states, personal pension products are recognized as available only to the high income earners and financially literate due to their complexity and the relatively high costs of managing those products. That is why the Pan-European Pension Product (PEPP) was designed in a way that is simple and transparent in its objective and features, while providing economies of scale to make the PEPP cost-efficient, so it can address the needs of the vast majority of European consumers.

One of EIOPA’s larger projects in recent years is the creation of a framework for a Pan-European Pension Product (PEPP). What is the status of PEPP at present?

Addressing the needs of a changing economic and demographic environment in the European Union alongside the long-standing challenges of ensuring the sustainable, adequate retirement income of future generations, the European Insurance and Occupational Pensions Authority (EIOPA) developed a Pan-European Personal Pension Product (PEPP) and welcomes the co-legislators’ decisive commitment to introduce a truly European, complimentary personal pension product. The draft regulation has entered the phase of trialogue negotiations, which are expected to be finalized by the end of this year or early 2019.

The PEPP, as a Pan-European product, is an important instrument to support mobile European citizens and workers to continue saving for their retirement income while moving from one member-state to another. Currently, mobile workers may own a number of small, often individually negligible, pension claims all over the European Union, unable to benefit from economies of scale and efficient asset management of bigger asset portfolios. Similarly, a significant number of citizens in the European Union do not have access to appropriate retirement savings products, due to highly fragmented markets for pension products as well as opaque, complex and consequently often unattractive individual pension products.

EIOPA believes the PEPP can overcome these hurdles and enable important individual savings for future retirement income, closing the ever-widening pension gap. The PEPP is designed to be a safe, transparent and cost-efficient retirement savings product, which builds on a good balance of standardization of important product characteristics and flexible elements to accommodate national and individual preferences. Overall, it is crucial for the product to enable cost efficiencies and economies of scale, achieving good, long-term sustainable returns and eventually good outcomes for future retirement incomes.

Central authorization of PEPPs by EIOPA is a decisive provision in the European Commission’s proposal for a PEPP regulation. A central, fully consistent, authorization at the European level endorses the European quality label and enables consumer trust, which allows for further efficiency gains and prevents potentially divergent practices. Through the authorization process, national competent authorities and EIOPA can set clear expectations on the composition of an application for authorization, timelines and the criteria to be used by EIOPA in approving any PEPP to be marketed throughout Europe. EIOPA believes that a European quality label requires a strong and efficient authorization process as well as central certification of key features by a European authority.

PEPP and its key features – for example the decumulation phase and portability solutions – require innovative, bold and smart solutions that work in a diverse pension landscape – that is the European Union – and are adapted to the common challenges of the European Union.

How could occupational funds be successfully incorporated in a specific country’s pension system?

Pensions are an important part of a member-state’s social security system. In the European Economic Area (EEA) there is a wide variety of different designs of pension systems, ideally built on all three pillars: state pensions, occupational pensions and complementary personal pensions. In times of stressed state budgets, the importance of private pensions for the individual increases drastically. Occupational pensions traditionally and successfully have built on sharing risks and rewards between pension scheme members – and have been sponsored by one or a number of employers – assuming long-term employment and corresponding long-term contribution to the pension fund. Mobility and unconventional career paths – short-term/part-time employment, self-employment and unemployment – challenge such traditional designs, as they cannot facilitate building up sufficient savings for the individual member. Similar to the considerations around PEPP, factors that may promote building successful occupational pensions are: transferability – easier to transfer are DC funds – default funds and auto-enrolment, meaning that citizens automatically become members of a pension fund, unless they opt out.

EIOPA is aiming to introduce more consistent supervision among member-states. How can this be achieved?

In a single market with cross-border activities and a passporting system supervised by the home country, the supervisory system is as strong as its weakest link. That is why ensuring high quality and consistent supervision is fundamental to the proper functioning of the single market. The Solvency II harmonized regulatory framework creates the conditions for this supervisory convergence.

EIOPA gives high priority to supervisory convergence and has been actively working to foster a common European Supervisory Culture and to ensure consistent supervisory practices. This a marathon not a 100-meter race.

In April, we published our 2018/2019 supervisory convergence plan in which we identified three main areas: First, the development of common supervisory tools and benchmarks, such as the application of proportionality, the common benchmarks for supervision of internal models and the supervisory assessment of conduct risks; second, the supervision of cross-border business, such as the detection of unsustainable cross-border business models, the sufficiency of technical provisions in cross-border business and the fit and proper analysis; and,  third, the supervision of emerging risks, such as the analysis of supervisory practices on IT resilience and cyber risks, the usage of big data and Brexit. 

In particular, EIOPA has built up and coordinated so-called cooperation platforms with home and host supervisors to look at concrete cases of companies with cross-border activities and their supervision. To date EIOPA has coordinated 13 platforms involving national supervisors from many different countries. For each platform, EIOPA provided concrete supervisory recommendations to the home supervisor. In some instances, these recommendations were aimed at strongly encouraging the home supervisory authority to initiate intrusive interventions toward the firm, such as prohibition of writing new business, in order to limit the risk to prospective policyholders.

The business models of the companies subject to a cooperation platform differ significantly, from motor insurance, construction business and medical malpractice insurance to complex unit-linked products. In general, the focus of the companies is on growth outside the home market and on long-tail business where the risk will only materialize in the medium- to long-term. Usually, there are insufficiencies in technical provisions, deficiencies in the data available and complex intermediation structures. The impact of failure of such companies can cause significant waves in the host markets and severely disrupt public trust in the functioning of the internal market.

The focus on supervisory convergence activities by EIOPA is also reflected in a growing number of peer reviews, of mediation cases and investigations into breaches of European Union law.

At the same time, there are limitations to the EIOPA’s current powers. That’s why EIOPA has been advocating for concrete amendments to the EIOPA Regulation to build a stronger framework for its independent assessment of supervisory practices through relevant further powers and preventive tools regarding cross-border business, namely through the right of initiative to set up cooperation platforms.

The lessons learned from the financial crisis and its effects on the insurance sector

What are the lessons learned from the financial crisis and the banking sector affecting the European insurance sector?

The 2007-2008 financial crisis clearly showed that the sources, magnitude and consequences of systemic risk were not sufficiently considered by relevant authorities and market participants, as their focus was on the soundness of individual financial institutions. The crisis highlighted the relevance of systemic risk and need of a new set of policies aimed at avoiding contagion and contributing to financial stability. Most of the initiatives developed in the aftermath of this crisis were targeted at the banking sector, which was at the epicenter of the financial crisis. Although the insurance sector differs substantially from the banking sector, some of the lessons learned from the banking experience are also useful for insurance.

For example, the need to supplement the microprudential policy approach, which seeks to limit the distress of individual institutions, with a macroprudential approach that focuses on system-wide distress became obvious. A sound macroprudential strategy that links objectives and a comprehensive set of instruments should be in place. In this respect, risk monitoring and assessment, e.g. via conducting regular stress test exercises but also through monitoring market-wide risks and vulnerabilities, need to be in place at sectoral levels.

Another relevant lesson learned is the need for coordination and cooperation at the supranational level. Given the high degree of interconnectedness in the financial system and possible spillover effects, the economic costs stemming from uncoordinated actions should be avoided.

How could a new major crisis in the insurance sector be prevented and what measures are being taken on a microprudential basis?

Crises are inherent to the functioning of modern market economies and, therefore, it is clear that they cannot be fully avoided. From a policy perspective, the aim should be to reduce the likelihood as well as the impact of crises and not exclusively in the insurance sector but in all financial sectors. In the case of the insurance sector, this two-dimension objective is linked to the applied prudential supervisory framework and the need for a comprehensive and harmonized recovery and resolution framework in the European Union. Solvency II – the European supervisory framework – has significantly improved the supervision of insurers across the European Union with its risk-based and forward-looking approach, which is essential for the prevention of future crises, aiming at reducing the likelihood of insurers’ failures. Furthermore, equally important is the consistent practical implementation of the framework across countries, safeguarding the common market and a level playing field. EIOPA has an important role in this area, in promoting and coordinating supervisory convergence in the European Union.

We must keep in mind, however, that Solvency II is not a zero failure regime. Insurers’ failures will take place and it is important that they do so in an orderly manner. A recovery and resolution framework covering relevant issues such as pre-emptive plans, early intervention measures and a common set of resolution powers would contribute in preventing crises by potentially limiting the impact of adverse developments on policyholders and financial stability. Unlike the banking sector, where the Bank Recovery and Resolution Directive (BRRD) was introduced in 2014, on the insurance side there has not yet been a concrete initiative by the European Commission and thus there is currently still a high degree of fragmentation.

Although the majority of troubled institutions were banks, insurers have not been fully immune to failure. The case of AIG is the most notorious, but in Europe, too, we have witnessed cases of insurance failures. In fact, the recently published EIOPA paper on insurance failures and near misses reported more than 87 cases of – partial or total – resolution and liquidation of European insurers since the year 2000. A harmonized and effective recovery and resolution framework would strengthen the preventative side and make the management side of a crisis more efficient and effective. This is particularly relevant in fragile market environments, like the current low interest rate environment that poses risks to insurers.

Could you elaborate on EIOPA’s stress tests? What’s the scope so far and what are the benefits?

EIOPA is required by its founding regulations to perform stress tests on a regular basis in order to assess the resilience of financial institutions to adverse market developments. Although, the overall objective is assessing the resilience of the sectors, EIOPA tailors the goal, scope and scenarios of each exercise according to the foreseen evolutions in market conditions and their potential negative implications for insurers and occupational pension funds.

The last pension stress test conducted in 2017 was designed to assess the resilience of the defined benefit (DB)/hybrid segment of the occupational pension (IORP) sector by applying an adverse market scenario to both the national and common market-consistent balance sheet, taking into account the available security mechanisms, i.e. sponsor support as well as pension protection schemes and benefit adjustment mechanisms. The exercise included all countries with material IORP sectors, exceeding 500 million euros in assets.

The ongoing 2018 insurance stress test is tailored to assess the vulnerability of the European insurance sector to specific adverse scenarios and is based on a sample of 42 large insurance groups. The scenarios encompass a wide range of risks, including market and insurance specific risks providing more insight into potential vulnerabilities from a financial stability perspective. What is important to mention here is that the EIOPA stress test is not a pass or fail, nor is it a capital exercise. It aims at assessing the impact of common European Union-wide scenarios, issuing recommendations and calling for supervisory follow-up actions in case vulnerabilities are identified that may pose a threat to the stability of the financial system.

Investment policies

How do the ultra-low – and in many cases negative interest rates – affect the investment policies of the insurance sector?

The prolonged low interest rate environment poses a challenge for the European insurance sector. Low long-term interest rates increase the present discounted value of the long-term liabilities in particular for life insurers, while at the same time making it harder to achieve the required investments returns to cover obligations toward policyholders, in particular for products with high investment guarantees issued in the past. Even though life insurers are trying to adapt to these circumstances by lowering investment guarantees and focusing on unit-linked products, not all of them are able to transform their business models to date. The recent analysis conducted by EIOPA on insurers’ investment behavior at a European level covering the years 2011, 2013, 2015 and 2016, led to the identification of a number of trends that could be associated with a search for yield behavior.  When looking at the developments in the investment allocation on an aggregate level, changes in all three main investment categories (bonds, equities and other investments) from 2011 to 2016 appear marginal. A trend toward quality fixed income securities with a lower credit rating was seen in the data, notwithstanding however the large number of sovereign and corporate downgrades occurring during the observation period. Moreover, a trend toward more illiquid investments such as non-listed equity and loans was identified, as well as an increase in the average maturity of the bond portfolio. In addition, the tendency to invest in new asset classes was observed and, although current exposures are still low compared to the size of the portfolios, almost 75 percent of the participating insurance groups responded positively toward increasing their investments in asset classes such as: infrastructure, mortgages, loans and real estate.

To sum up, the low yield environment has influenced the investment portfolio of insurers. The trends identified may impact the risk profile of undertakings and the sector as a whole and therefore require close monitoring by the supervisory community.