## _cr07124

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---

### Executive Summary
- The Danish life insurance and general pension fund industry is well-developed and an important part of Danish social policy, supported by taxation rules.
- Industry concentration is high and the business model of offering guaranteed rates is only gradually changing with the introduction of unit link products whereby the policy holder carries the risk.
- Most companies still offer guaranteed returns, although at levels that reflect current market conditions.
- The sector is sensitive to a range of risks on both the asset and liability side:
  - Susceptible to low interest rates, low equity and property prices.
  - Mortality risk from increased longevity.
- Measures implemented:
  - Increase provisions and capital.
  - Hedging interest rate risk through derivatives.
- Stress scenario implication:
  - In a scenario with overall negative financial market development, low investment returns, and changes in longevity, the level of provisions and buffer capital in the sector will be vital.
- Policy implication:
  - Sound risk management by life insurance institutions and effective DFSA oversight are essential given persistent guaranteed-return business models and embedded options not explicitly priced.

### Introduction — Scope and purpose
- Technical focus:
  - Implications of commitments by life insurance companies and pension funds to pay returns exceeding current yields on government securities.
  - Brief description of the Danish life insurance and pension industry.
  - Review of DFSA measures addressing guaranteed high yields in a low yield environment.
  - Encouragement for authorities to maintain continued diligence.
- International context:
  - Similar challenges faced by many life insurance companies internationally; DFSA has applied measures used elsewhere and acted proactively.

### Pension Products — Product mix and guarantees
- Major product characteristics:
  - Supplementary pension for employees; major products are traditional life annuities with a guaranteed interest rate.
  - Typical contribution rates for mandatory pension schemes in labor market agreements: "12 to 17 percent of the wage," split between employer and employee.
  - Contribution determines fully paid up pension benefit; benefit size depends on age, sex, retirement age, guaranteed interest rate, and contribution.
- Product distribution (Gross Premiums, Percent):
  - With profit contracts—nonlinked: 2000 88.1; 2003 83.4; 2004 82.3; 2005 75.7
  - Term risk: 2003 1.4; 2004 1.7; 2005 4.6
  - Unit linked insurance: 2000 5.1; 2003 6.6; 2004 8.8
  - Unit linked life insurance—with zero percent return option: 2000 2.6; 2003 1.7; 2004 0.9; 2005 1.6
  - Group pension insurance: 2000 9.2; 2003 8.4; 2004 8.5; 2005 9.3
- Historical maximum technical interest rate changes:
  - Until mid-1994: commonly 4.5 percent.
  - 1994: DFSA lowered maximum technical interest rate to 2.5 percent; many companies changed guarantees from American to European style options.
  - 1999: maximum technical interest rate reduced to 1.5 percent.
  - Agreed guaranteed interest rate applies throughout life of in-force pension schemes; contracts up to mid-1994 still yield 4.5 percent guarantee.
- Market evolution:
  - Unit link products introduced in late 1980s; market share increasing.
  - Some unit linked products include embedded zero interest rate option.
  - New schemes and run-off of older high-guarantee schemes expected to lower overall risk over time.
- Profit distribution and bonus principles:
  - Contribution principle distributes realized result between owners and policyholders according to contribution; applies to losses.
  - Return on equity calculated on a residual basis.
  - Policyholder bonuses usually based on the average-return principle; all policyholders receive same return irrespective of individual schemes.

- Return on equity (percent), 2000–2005:
  - Return on equity before tax: 2000 4.11; 2001 -15.96; 2002 -12.68; 2003 19.66; 2004 17.59; 2005 17.82
  - Return on equity after tax: 2000 3.94; 2001 -14.31; 2002 -10.59; 2003 18.15; 2004 15.91; 2005 15.65

### Investments — Market structure, portfolio composition, returns
- Market characteristics:
  - Danish capital market well developed and quite efficient.
  - Bond market among largest in Europe, primarily mortgage and government bonds.
  - Danish equity market relatively small; market capitalization increases mainly from equity price rises.
  - International investment: 72 percent of equity portfolios in foreign equities; 28 percent of bond portfolios in foreign bonds.
  - Danish interest rates trended downward; equity prices trended upward.
  - Yield on 10-year government bonds has not been sufficient to cover 4.5 percent guaranteed returns in recent years.
- Asset mix (selected years):
  - 2005 (2004): bonds 56.2 (61.7) percent of total investment assets; equities 15 (13.8) percent.
- Total investments and selected components (values preserved as presented):
  - Total investments: 118,490 (2000); 120,579 (2002); 144,643 (2004); 167,289 (2005) — Percent of Total 100.0 each year.
  - Bonds: 61,002 51.5 (2000); 84,769 70.3 (2004); 89,227 61.7 (2004); 94,026 56.2 (2005).
  - Participating interests / Equities: 36,630 30.9 (2000); 14,700 12.2 (2002); 19,974 13.8 (2004); 25,113 15.0 (2005).
  - Investments in subsidiary and associated companies: 10,785 9.1 (2000); 6,179 5.1 (2002); 8,440 5.8 (2004); 19,644 11.8 (2005).
  - Interests in investment associations: 5,692 4.8 (2000); 7,962 6.6 (2002); 18,981 13.1 (2004); 14,773 8.8 (2005).
  - (Land and buildings and Other investments figures preserved in source table.)
- Returns and costs:
  - Return on investments before tax: 2000 5.65; 2001 -1.63; 2002 1.77; 2003 6.86; 2004 10.40; 2005 14.25
  - Return on investments after tax: 2000 4.95; 2001 -1.20; 2002 1.71; 2003 6.05; 2004 9.11; 2005 12.46
  - Administration costs: 2001 6.49 percent; 2005 5.33 percent
- Market liquidity risks:
  - Large institutional positions imply potential illiquidity if rapid changes in investment mix are required, especially in equity market.
  - Danish bond market large and relatively liquid; equity market illiquidity a greater concern.

### Use of derivatives, hedging, and sensitivity management
- Hedging developments:
  - Recent years: life insurers and pension funds have hedged all or part of interest-rate risk via financial derivatives.
  - Hedging important due to liabilities' sensitivity to guaranteed returns and asset exposure to Danish callable mortgage bonds.
- Regulatory changes and limits:
  - 2000: regulatory limit for investments in equities raised to 70 percent of technical provisions conditional on improved asset–liability matching.
  - Spring 2001 Finanstilsynet simulation: approximately 35 undertakings unable to cope with simulated adverse market development.
  - June 2001 introduction of red and yellow light stress test scenarios and reporting regimes.
- Stress test scenarios (parameters preserved):
  - Red light scenario:
    - Decrease of 12 percent in the price of stocks.
    - Decrease of 8 percent in the price of real estate.
    - Change of the interest rate level of 0.7 percentage points.
    - Technical provisions discounted on a risk-free interest rate curve (EURO-swap curve). Credit and foreign exchange risks stressed as well.
    - Companies report biannually; failure to meet red scenario leads DFSA to require monthly reporting and prohibits increasing overall risk.
  - Yellow light scenario:
    - Decrease of 30 percent in the price of stocks.
    - Decrease of 12 percent in the price of real estate.
    - Change of the interest rate level of 1.0 percentage point.
    - Failure to meet yellow scenario triggers quarterly reporting.
  - As of end-2005: one company flagged under red light (nonlife company) and six companies under yellow light.
- Biometric risk stress tests:
  - Required disclosure in annual report.
  - Test assumptions:
    - Decrease and increase in mortality intensity of 10 percent (corresponds roughly to changes in longevity of one year).
    - Increase in disability intensity of 10 percent.

### Asset–Liability Management — vulnerabilities and responses
- Principal vulnerability:
  - Requirement to achieve high guaranteed returns for duration of in-force policies (several decades) amid lower returns and mortality risk.
  - Agreed guaranteed interest rate applies through life of in-force schemes, creating long-duration liabilities.
- Risk management implications:
  - Need for adequate provisions and buffer capital.
  - Importance of derivatives hedging and asset reallocation.
  - Structural responses by firms include dividing portfolios into policy blocks or transferring portfolios to separate companies to match investment policy to guarantees.

### Solvency — capital adequacy, buffers, and recent history
- Capital and buffers:
  - DFSA measures: stress tests (traffic light system) and fair value accounting on assets from 2002 and liabilities from 2003.
  - Several firm-level measures implemented to increase provisions and capital.
- Solvency ratio (percent):
  - 2000 4.2; 2001 2.4; 2002 2.2; 2003 2.6; 2004 2.7; 2005 2.6
  - Since 2003 solvency capital at 2.6 percent or above.
  - 2005: 10 percent of companies with least capital had solvency ratio below 1.5—none less than 1.2; 10 percent of best capitalized companies had solvency ratio exceeding 6.4.
- Failures and restorations:
  - Four life insurers and general pension funds did not meet solvency requirements during last five years; capital restored by DFSA-accepted restoration plans.
  - Causes: investment losses and mismatch between interest rate sensitivity on assets and liabilities.
  - All companies continued operations; no direct losses to policyholders or owners observed.

### Distribution disputes, transfers, and corporate structure
- Court cases:
  - Presently, court cases in progress concerning distribution of bonus and profits; may impact profit distribution practices.
- Policyholder transfers:
  - Policyholders allowed to transfer contracts between companies but not entitled to undistributed profits (collective bonus reserves).
  - Transfer activity limited by non-entitlement to undistributed profits and high administrative transfer costs.
  - Industry measures initiated (after Bremer Committee report) to simplify and lower transfer costs to encourage competition.
- Distribution of pension liabilities by guaranteed interest levels (Table 5):
  - Life insurance companies: 0 Percent 3; 0 - 2 Percent 25; 2 - 4 Percent 20; over 4 Percent 52
  - General pension funds: 0 Percent 2; 0 - 2 Percent 12; 2 - 4 Percent 31; over 4 Percent 55
  - Estimated that over half of life insurance companies and general pension funds liabilities are still based on the maximum technical interest rate of 4.5 percent.

### Pension asset growth, market structure, and entities (2004–2005)
- Pension asset growth:
  - 2005 total pension assets grown by almost 17 percent — largest growth in last five year period.
  - Credit institutions and ATP experienced largest increase, followed by life insurance companies.
- Pension assets by entity (Billions DKr; Percent of Total Value):
  - Life insurance companies: 2004 810 (43.9); 2005 953 (44.2)
  - General pension funds: 2004 339 (18.4); 2005 381 (17.7)
  - Company pension funds: 2004 39 (2.1); 2005 42 (1.9)
  - Credit institutions: 2004 244 (13.2); 2005 298 (13.8)
  - ATP: 2004 307 (16.7); 2005 365 (16.9)
  - SP: 2004 46 (2.5); 2005 51 (2.5)
  - LD: 2004 58 (3.2); 2005 64 (3.0)
  - Total: 2004 1,844 (100.0); 2005 2,154 (100.0)
- Market structure counts (2000–05):
  - Life insurance companies: 2000 63; 2001 58; 2002 43; 2003 41; 2004 37; 2005 36
  - General pension funds: 2000 31; 2001 31; 2002 31; 2003 30; 2004 30; 2005 29
  - Company pension funds: 2000 54; 2001 50; 2002 47; 2003 47; 2004 44; 2005 44
  - Effective groups in 2005: 18 life insurance companies/pension funds (groups)
- Market concentration (gross premiums percent of total):
  - Top 5 total: 2003 57.4; 2004 55.3; 2005 59.9
  - Top 10 total: 2003 74.4; 2004 73.4; 2005 79.0
  - 2005 commercial market: top 5 89.2; top 10 99.9
- Cross-border activity limited due to tax deductibility rules; some Danish companies controlled by foreign banks and insurance groups.
- Distribution channels: direct sales, sales through banks, sales through intermediaries; labor market parties largely decide supplier, premium level, and coverage.

### Company pension funds, ATP, SP, LD overview
- Company pension funds:
  - Administer schemes for employees of a single company or group.
  - Three company pension funds for TDC account for more than half of company pension funds' assets.
  - Total assets of company pension funds approximately Dkr 39 billion (about 2 percent of total pension assets).
- ATP:
  - Largest funded pension plan established by law; mandatory for all employees.
  - Assets approximately DKr 365 billion (almost 17 percent of total pension assets).
- SP:
  - Funded with contributions amounting to 1 percent of personal income; contributions suspended in 2004 and 2005.
  - Assets approximately DKr 51 billion (2.4 percent of total pension assets).
- LD:
  - Established end-1970s; government decided to use LD as supplementary lump sum pension upon retirement.
  - Assets approximately Dkr 64 billion (almost 3 percent of total pension assets).

*Source: _cr07124 — IMF staff summary of the Danish Financial Supervisory Authority material contained in the referenced chapter.*

### Executive Summary ......................................................................................................

### Executive Summary

### Key findings
- The Danish life insurance and general pension fund industry is well-developed and an important part of Danish social policy, supported by taxation rules.
- The industry is quite concentrated and the business model of offering guaranteed rates is only gradually changing with the introduction of unit link products whereby the policy holder carries the risk.
- Most companies are still offering guaranteed returns, although at levels that reflect current market conditions.
- The sector is sensitive to a range of risks on both the asset and liability side of the balance sheet:
  - The sector remains susceptible to low interest rates, and also to other market risks, including low equity and property prices.
  - Mortality risk from increased longevity is an issue.
- Several measures have been implemented to increase provisions and capital, and for hedging interest rate risk through derivatives, but overall risk still needs close monitoring.
- In a scenario with an overall negative development in the financial markets and associated low returns on investments, along with changes in longevity, the level of provisions and buffer capital in the life insurance and pension sector will be vital.
- The range of risk factors places an important premium on sound risk management by life insurance institutions and effective oversight by supervisors.

*Source: _cr07124 - Executive Summary*

---

### Introduction

### Scope and purpose
- The technical note focuses on the implications of the commitment of life insurance companies and pension funds to pay returns exceeding the current yields on government securities.
- It:
  - briefly describes the life insurance and pension industry in Denmark;
  - reviews the measures the Danish Financial Supervisory Authority (DFSA) has used to address guaranteed high yields in a low yield environment;
  - encourages the authorities to maintain continued diligence.
- International context: many life insurance companies internationally face similar challenges. The DFSA has applied measures used in other countries and acted proactively, but continued diligence is warranted because the guaranteed-return business model is still being used without explicitly pricing the implied options.

### Industry characteristics
- Dominated by a relatively small number of groups; major insurance products are traditional with-profit pension schemes with minimum guaranteed rates of return.
- Historical performance: the Danish life insurance industry has historically produced adequate profits, but the dominance of guaranteed life products and associated asset-liability matching concerns make results contingent on asset-side performance.
- Note on structure: the note is organized into sections covering products, investments, asset/liability sensitivity, solvency and buffer capital, with an appendix describing industry structure.

---

### Pension Products

### Product mix and guarantees
- The life insurance companies and general pension funds mainly provide a supplementary pension—mandatory pension scheme for employees—where major products are traditional life annuities with a guaranteed interest rate.
- Typical contribution rates for mandatory pension schemes that are part of labor market agreements are "12 to 17 percent of the wage," split between employer and employee.
- The contribution from each employee is used to buy a fully paid up pension benefit each year; the size of the benefit depends on age, sex, retirement age, the level of guaranteed interest rate, and the contribution.

### Product distribution (Gross Premiums, Percent)
- 2000, 2003, 2004, 2005 distribution of major product types:
  - With profit contracts—nonlinked: 88.1, 83.4, 82.3, 75.7
  - Term risk: 1.4, 1.7, 4.6
  - Unit linked insurance: 5.1, 6.6, 8.8
  - Unit linked life insurance—with zero percent return option: 2.6, 1.7, 0.9, 1.6
  - Group pension insurance: 9.2, 8.4, 8.5, 9.3

### Historical maximum technical interest rates and contract implications
- Until mid-1994, a maximum technical interest rate of 4.5 percent was commonly applied on traditional with profit contracts.
- In 1994, DFSA lowered the maximum technical interest rate to 2.5 percent; many companies also changed guarantees from American options to European style options.
- In 1999, the maximum technical interest rate was reduced further to 1.5 percent.
- The agreed guaranteed interest rate applies throughout the life of an in-force pension scheme, so agreements established up to mid-1994 still yield a guaranteed rate of interest of 4.5 percent.
- Wage raises are not covered in old contracts with high guaranteed return, but will be covered by new contracts with lower guaranteed returns—this eases the problem of fulfilling high returns on in-force policies.
- Life insurance institutions may create pension schemes based on lower guaranteed rates or without any guarantee.

### Market evolution and product design
- The market for individual life insurance contracts and unit link products is limited but unit link products were introduced in the late 1980s and their market share has begun to increase recently.
- Some life insurance companies have introduced unit linked products with an embedded zero interest rate option.
- For new pension schemes there is greater scope for development; several companies have introduced zero interest guarantee schemes or unit linked schemes. Over time, new schemes and run-off of older schemes will lower overall risk related to high guaranteed return contracts.

### Profit distribution and bonus principles
- Profit distribution is based on the "contribution principle"—distribution of realized result between owners and policyholders on a fair basis according to contribution to the result. The contribution principle also applies to losses.
- The return on equity is calculated on a residual basis and is not solely dependent on the result for the year.
- Policyholder bonuses are usually based on the average-return principle—all policyholders receive the same return irrespective of individual schemes; returns are determined by company bonus policy and investment yield development over several years. This levels yield over time, supporting stable development but redistributes between groups of policyholders.
- Owners and policyholders may have diverging interests regarding profit distribution: owners may prefer carrying profit to equity capital; policyholders may prefer distribution to policyholders. Rules for return on equity typically include a return aligned with yield to policyholders and a reasonable risk premium.

### Return on equity (percent), 2000–2005
- Return on equity before tax: 2000 4.11, 2001 -15.96, 2002 -12.68, 2003 19.66, 2004 17.59, 2005 17.82
- Return on equity after tax: 2000 3.94, 2001 -14.31, 2002 -10.59, 2003 18.15, 2004 15.91, 2005 15.65
- Note: The ratio of profit before/after tax to average equity capital.

---

### Investments

### Risk exposure and hedging
- The sector is sensitive to low interest rates, low equity and property prices, and longevity risk.
- Measures implemented include increasing provisions and capital, and hedging interest rate risk through derivatives.
- The DFSA has encouraged hedging and these practices are widely used by the industry.

### Regulatory and supervisory responses (selected)
- DFSA measures described in Box 1 include:
  - Adjusting methodology, requiring additional technical reserves, or more capital.
    - DFSA has introduced stress test—the traffic light system—and fair value accounting on all assets from 2002 and on liabilities from 2003 to assess capital adequacy.
  - Encouraging hedging exposures (market based approach; can be expensive if late).
  - Allowing riskier investments with higher expected returns provided higher solvency capital, e.g., DFSA eased the limit for investing in equities in 2000.
  - Changing bonus allocation between policyholders and owners (legal and contractual issues).
  - Reducing the yield to below the guaranteed yield due to force majeure (not allowed in Denmark; could be challenged in court).
  - Separate policy statutory funds for new and old contracts within same company (used in Denmark).
  - Separate company for new and old contracts (used by some Danish companies).
  - Voluntary portfolio transfer as a going concern (requires policyholder permission in many jurisdictions).
  - Run-off a portfolio while technical reserves are adequate.
  - Winding up: transfer to insurance protection fund when technical reserves are inadequate (Denmark only has a nonlife insurance protection fund).
  - Bankruptcy: owners may lose capital; policyholders may lose coverage where no protection fund applies.
  - New contracts: unit linked products where policyholder carries investment risk (in Denmark, this business is still modest but increasing).
  - Yield commitment contingent on market developments (indexing the guaranteed yield).
  - Yield commitments at a lower guaranteed rate (used in Denmark, but embedded options may not be explicitly valued).

---

### Asset-Liability Management

### Main considerations
- Principal vulnerability arises from the requirement to achieve a high guaranteed return for the duration of in-force policies, which may span several decades, in an environment where higher returns are more difficult to achieve and there is mortality risk.
- The agreed guaranteed interest rate applies through the life of in-force pension schemes, locking in long-duration liabilities.
- The combined effects of market risks and longevity increases make asset-liability management crucial.

### Risk management implications
- Sound risk management by life insurance institutions and effective oversight by supervisors is essential due to:
  - sensitivity to low interest rates and market downturns;
  - the long duration of guaranteed commitments;
  - increasing longevity and associated mortality risk;
  - the need for adequate provisions and buffer capital to absorb adverse scenarios.

---

### Solvency

### Capital adequacy and buffers
- The DFSA has implemented measures to assess capital adequacy, including stress tests (traffic light system) and fair value accounting on assets (from 2002) and liabilities (from 2003).
- Several measures have been implemented by firms to increase provisions and capital.
- The level of provisions and buffer capital will be vital under scenarios of negative financial market developments, low investment returns, and changes in longevity.

### Policy implications
- Continued regulatory diligence is encouraged given:
  - the persistence of guaranteed-return business models without explicit pricing of embedded options;
  - the concentration of the industry and the potential systemic implications;
  - the need to monitor the adequacy of technical reserves, the use of derivatives for hedging, and the appropriateness of profit distribution mechanisms in stress scenarios.

*Source: _cr07124 - Executive Summary*

### 13.      Presently, there are court cases in progress concerning the distribution of bonus

### _cr07124 - 13.      Presently, there are court cases in progress concerning the distribution of bonus

### Distribution disputes and policyholder transfers
- Presently, there are court cases in progress concerning the distribution of bonus and profits. These court cases may have an impact on how profits are distributed in the life insurance companies and general pension funds.
- Policyholders are allowed to transfer their contracts from one company to another, but are not entitled to undistributed profits (collective bonus reserves).
- Transfer activity has been limited by:
  - the restriction that transferring policyholders are not entitled to undistributed profits, and
  - high administrative costs charged in the event of transfers.
- As a result of a report from the Bremer Committee, the life insurance industry has initiated measures to simplify and lower the cost on transfers with the objective to encourage competition.

### Investments: market structure and portfolio composition
- The Danish capital market is described as well developed and quite efficient.
- The bond market is among the largest in Europe, comprising primarily mortgage and government bonds.
- The Danish equity market is relatively small, with market capitalization increasing mainly due to booming equity prices.
- Life insurance companies and general pension funds invest internationally: 72 percent of the equity portfolios are in foreign equities and 28 percent of bond portfolios are in foreign bonds.
- Historical trends:
  - Danish interest rates have trended downward in recent years, while equity prices have trended upward.
  - The yield on 10-year government bonds has not been sufficient to cover the guaranteed returns of 4.5 percent in recent years.
- Asset mix (selected years):
  - In 2005 (2004), bonds and equities accounted for 56.2 (61.7) and 15 (13.8) percent, respectively, of total investment assets.
- Table 3 (summary numbers preserved from source):
  - Total investments: 118,490 (2000); 120,579 (2002); 144,643 (2004); 167,289 (2005) — Percent of Total indicated as 100.0 for each year.
  - Bonds: 61,002 51.5 (2000); 84,769 70.3 (2004); 89,227 61.7 (2004); 94,026 56.2 (2005).
  - Participating interests / Equities: 36,630 30.9 (2000); 14,700 12.2 (2002); 19,974 13.8 (2004); 25,113 15.0 (2005).
  - Investments in subsidiary and associated companies: 10,785 9.1 (2000); 6,179 5.1 (2002); 8,440 5.8 (2004); 19,644 11.8 (2005).
  - Interests in investment associations: 5,692 4.8 (2000); 7,962 6.6 (2002); 18,981 13.1 (2004); 14,773 8.8 (2005).
  - Land and buildings and Other investments figures are preserved in the table as presented.
- Returns and costs:
  - Return on investments before tax: 5.65 (2000); -1.63 (2001); 1.77 (2002); 6.86 (2003); 10.40 (2004); 14.25 (2005).
  - Return on investments after tax: 4.95 (2000); -1.20 (2001); 1.71 (2002); 6.05 (2003); 9.11 (2004); 12.46 (2005).
  - Administration costs reduced from 6.49 percent in 2001 to 5.33 percent in 2005.
- Market liquidity risks:
  - Large institutional positions imply potential illiquidity if rapid changes in investment mix are required, especially in the equity market.
  - The Danish bond market is large and relatively liquid; equity market illiquidity is a greater concern, including for individual securities in stress scenarios.

### Asset–liability management and regulatory responses
- DFSA measures since 2000 to address asset–liability mismatch:
  - Maximum technical interest rate has been lowered several times.
  - In June 2001, reporting according to the “traffic light system” and accompanying additional capital requirements were introduced.
  - Fair value accounting introduced on all assets from 2002 and on liabilities from 2003.
  - Increased provisioning and buffer capital; change in asset allocation; increased hedging of interest risk through derivatives.
- Contract heterogeneity and conflicts of interest:
  - Reduction of the maximum technical interest rate led to schemes with different guaranteed rates of return.
  - Potential conflicts: contracts with low guaranteed returns may pursue higher-risk investments compared with contracts with high guaranteed returns.
  - As of recent years covered, results have been sufficient to provide a return above the 4.5 percent guaranteed return to all policyholders; this could change if returns decrease significantly.
- Structural responses:
  - Some firms have divided portfolios into policy blocks or transferred portfolios to separate companies to match investment policy to guarantees and clarify legal framework.

- Distribution of pension liabilities by guaranteed interest levels (Table 5):
  - Life insurance companies: 0 Percent: 3; 0 - 2 Percent: 25; 2 - 4 Percent: 20; over 4 Percent: 52.
  - General pension funds: 0 Percent: 2; 0 - 2 Percent: 12; 2 - 4 Percent: 31; over 4 Percent: 55.
- It is estimated that over half of life insurance companies and general pension funds liabilities are still based on the maximum technical interest rate of 4.5 percent.

### Use of derivatives and sensitivity management
- Recent years: life insurance companies and general pension funds have hedged all or part of interest-rate risk via financial derivatives.
- Hedging is significant given:
  - Liabilities sensitivity to guaranteed returns.
  - Assets exposure to large share of Danish callable mortgage bonds.
- Figures and studies referenced:
  - Figure 2 shows development in level of derivative contracts (1998–2005) versus interest rates.
  - Figure 3 illustrates net interest rate sensitivity with and without derivatives (2003–05), noting extrapolation between four calculated points.
  - Research referenced: Use of Derivatives to Hedge Embedded Options: The Case of Pension Institutions in Denmark by Jeppe Ladekarl, Regitze Ladekarl, Erik Andersen, and Dimitri Vittas, World Bank Working Paper, forthcoming.
- Regulatory limit and stress testing:
  - In 2000, regulatory limit for investments in equities was raised to 70 percent of the technical provisions, conditional on improved asset–liability matching.
  - Spring 2001 Finanstilsynet simulated adverse market developments; approximately 35 undertakings were unable to cope with the simulated adverse market development.
  - June 2001 introduction of red and yellow light stress test scenarios and reporting regimes.

### Stress test scenarios and biometric risk testing
- Red light scenario:
  - Decrease of 12 percent in the price of stocks.
  - Decrease of 8 percent in the price of real estate.
  - Change of the interest rate level of 0.7 percentage points.
  - Technical provisions discounted based on a risk-free interest rate curve (EURO-swap curve). Credit and foreign exchange risks are stressed as well.
  - Companies report results biannually. Failure to meet red scenario leads DFSA to require monthly reporting and prohibits increasing overall risk.
- Yellow light scenario:
  - Decrease of 30 percent in the price of stocks.
  - Decrease of 12 percent in the price of real estate.
  - Change of the interest rate level of 1.0 percentage point.
  - Failure to meet yellow scenario triggers quarterly reporting.
  - As of end-2005, the system flagged one company (nonlife company) under red light and six companies under yellow light.
- Biometric risk stress test:
  - All life insurers and pension funds must estimate consequences of changes in assumed mortality and disability levels used in the annual report.
  - Test assumptions:
    - Decrease and increase in mortality intensity of 10 percent (corresponds roughly to changes in longevity of one year).
    - Increase in disability intensity of 10 percent.
  - Results of these stress tests are required to be disclosed in the annual report.

### Solvency, buffers, and recent history
- Three sources of capital to absorb losses without affecting guaranteed benefits:
  - (i) the collective bonus potential (policyholders’ undistributed reserves),
  - (ii) the bonus potential for fully paid pension benefits,
  - (iii) the capital/own funds (belongs to owners).
- Collective bonus potential: policyholders’ collective undistributed reserves against asset value fluctuations and negative insurance risks and costs; excess must be distributed to policyholders.
- Solvency capital trends:
  - Solvency capital has been volatile but since 2003 has been at 2.6 percent or above.
  - Table 6: Solvency ratio in percent: 4.2 (2000); 2.4 (2001); 2.2 (2002); 2.6 (2003); 2.7 (2004); 2.6 (2005).
  - In 2005, 10 percent of companies with least capital had solvency ratio below 1.5—none less than 1.2—and 10 percent of the best capitalized companies had solvency ratio exceeding 6.4.
- Recent solvency failures and resolutions:
  - Four life insurers and general pension funds did not meet solvency requirements during the last five years; capital restored by DFSA-accepted restoration plans.
  - Failures were due to investment losses (decrease of equity prices and low interest rates) and mismatch between interest rate sensitivity on assets and liabilities.
  - All companies continued operations; no direct losses to policyholders or owners observed.

### Appendix — Structure of the Danish Pension System (key features)
- Three-pillar system:
  - First pillar: entitlement to an old-age pension from the age of 65, and the Danish Labor Market Supplementary Pension Fund ATP scheme.
  - Second pillar: mandatory labor market pension schemes, the Special Pension Savings Scheme (SP), and the LD Pension Fund.
  - Third pillar: private and individual pension savings.
- First pillar old-age pension is tax-funded and “pay as you go”; other schemes are funded.
- Funded pension schemes are paid by employers and employees without government contributions; contributions are tax deductible.
- Three main funded scheme types: (i) schemes established by law; (ii) schemes established by agreements between parties in the labor market; (iii) individual schemes.
- General retirement age for pillar I: 65; some schemes include options for early retirement (e.g., from age 60). Most schemes include death benefit (lump sum), disability, and old-age/survivor pensions; spouse and child pensions are usual.
- Management and providers:
  - Funded mandatory schemes ATP, SP, and LD are managed in specific funds.
  - Mandatory labor market schemes provided by life insurance companies, general pension funds, company pension funds, and credit institutions.
  - Individual schemes concluded in life insurance companies and credit institutions.
- Aggregate scale:
  - At end-2004, total assets of these providers amounted to 126¼ percent of GDP.

*Source: IMF staff summary of the Danish Financial Supervisory Authority material contained in the referenced chapter.*

### 38.      In 2005, total pension assets have grown by almost 17 percent. This is the largest

### _cr07124 - 38.      In 2005, total pension assets have grown by almost 17 percent. This is the largest

### Pension asset growth and composition (2004–2005)
- In 2005, total pension assets have grown by almost 17 percent. This is the largest growth in the last five year period.
- Credit institutions and the ATP have experienced the largest increase, followed by the life insurance companies.
- The schemes based on law accounts for 22 percent, and the life insurance companies and general pension funds accounts for 62 percent of the total pension assets.
- Table 7. Pension Assets by Types of Entities, End-2004 and End-2005 (values in Billions DKr; Percent of Total Value):
  - Life insurance companies: 2004 — 810 (43.9); 2005 — 953 (44.2)
  - General pension funds: 2004 — 339 (18.4); 2005 — 381 (17.7)
  - Company pension funds: 2004 — 39 (2.1); 2005 — 42 (1.9)
  - Credit institutions: 2004 — 244 (13.2); 2005 — 298 (13.8)
  - ATP: 2004 — 307 (16.7); 2005 — 365 (16.9)
  - SP: 2004 — 46 (2.5); 2005 — 51 (2.5)
  - LD: 2004 — 58 (3.2); 2005 — 64 (3.0)
  - Total: 2004 — 1,844 (100.0); 2005 — 2,154 (100.0)
- Source for table: Danish Financial Supervisory Authority.

### Market structure — life insurance and general pension funds
- At end-2005:
  - 36 life insurance companies
  - 29 general pension funds
  - Some entities organized as groups, effectively 18 life insurance companies/pension funds (groups) in 2005.
  - 44 company pension funds.
- Table 8. Number of Life Insurance Companies and Pension Funds, 2000–05:
  - Life insurance companies: 2000 — 63; 2001 — 58; 2002 — 43; 2003 — 41; 2004 — 37; 2005 — 36
  - General pension funds: 2000 — 31; 2001 — 31; 2002 — 31; 2003 — 30; 2004 — 30; 2005 — 29
  - Company pension funds: 2000 — 54; 2001 — 50; 2002 — 47; 2003 — 47; 2004 — 44; 2005 — 44
- Market entry and exit dynamics:
  - New entrants and exits at legal-entity level over last 10 years, largely within insurance groups due to changes in tax rules.
  - At life insurance group level, number of companies largely unchanged.
  - No exits caused by winding-up or other insolvency procedures.
  - Recent mergers among a couple of general pension funds; further consolidation depends on labor market parties.
- Market concentration (life insurance companies and general pension funds; gross premiums percent of total), 2003–05 (select figures from Table 9):
  - Top 5 total: 2003 — 57.4; 2004 — 55.3; 2005 — 59.9
  - Top 10 total: 2003 — 74.4; 2004 — 73.4; 2005 — 79.0
  - In 2005, the top 5 companies had a market share of 59.9 percent and the top 10 companies had a market share of 79 percent.
  - In the commercial market, the top 5 companies have a market share of 89.2 percent and the top 10 companies had a market share of 99.9 percent.
- Cross-border activity:
  - Cross-border activities are limited for both foreign insurers operating in Denmark and Danish insurers operating abroad, primarily because premiums paid to foreign undertakings according to the tax law are not tax deductible for the insured.
  - Some life insurance companies are controlled by foreign banks and insurance groups.
- Distribution channels:
  - Major distribution channels are direct sales from the insurer, sales through banks, and sales through intermediaries.
  - For life insurance and pensions, parties of the Danish labor market as part of labor market agreements largely decide the supplier as well as the level of premiums and coverage.

### Company pension funds
- Company pension funds administer pension schemes for all employees or a group of employees in a single company, or for employees in companies that belong to the same group.
- Three company pension funds for the telephone operator TDC account for more than half of the total assets of the company pension funds.
- The total assets of company pension funds are approximately Dkr 39 billion (about 2 percent of the total pension assets).

### ATP, LD, and SP schemes
- ATP:
  - ATP is the largest funded pension plan established by law and is a mandatory scheme for all employees.
  - Contributions are deducted from salary and paid to the ATP by employers.
  - Funds are invested and, together with profits, used for annuities for members from the age of 65.
  - The assets in the ATP amount to approximately DKr 365 billion (almost 17 percent of total pension assets).
- SP:
  - SP is funded with contributions amounting to 1 percent of personal income, but contributions were suspended in 2004 and 2005.
  - The assets of the SP amount to approximately DKr 51 billion (or 2.4 percent of the total pension asset).
- LD:
  - LD Pension Fund was established by law at the end of the 1970s; contributions were collected during 1977–79.
  - The government has decided to use the LD as a supplementary lump sum pension upon retirement.
  - The assets of the LD amount to approximately Dkr 64 billion (or almost 3 percent of total pension assets).

*Source: Extract from Appendix 1. The Structure of the Danish Pension System (continued and concluded) contained in the provided PDF content.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2007/_cr07124.pdf_