## _wp09151

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### Purpose and scope
- Discusses key sources of vulnerabilities and transmission channels to the rest of the financial sector and real economy for the pension and insurance sectors associated with the global financial crisis of 2008.
- Does not quantify the impact on pension and insurance balance sheets given heterogeneity of arrangements.
- Aims to draw related policy implications.

### Geographic and institutional focus
- Focus on OECD and Latin American countries.
- Notes substantial heterogeneity across:
  - pension arrangements: mandatory and voluntary plans, specialized pension annuity companies, pure asset management pension plans, other plans with diverse financial and biometric guarantees;
  - actuarial, solvency and accounting standards (even within countries);
  - insurance sector structures: large companies, parts of large financial groups, wide array of risks and financial guarantees.
- Notes ongoing efforts to develop more risk-based international standards (example cited: European Solvency II).

### Institutional role and risk-sharing properties
- Contractual savings (pension plans and life insurance) channel personal sector savings, enable lifecycle consumption smoothing, and can increase stock and bond market depth.
- Contractual savings effects:
  - Shift intermediation from banks to capital markets.
  - Increase stock market depth where pension contributions are mandatory.
  - Increase bond market depth where corporates rely more on bank financing.
- Insurance role:
  - Transfer risks from corporate and household sectors.
  - Reinsurance enables primary insurers to manage catastrophic risk.

### Key pension plan dimensions and types
- Three analytical dimensions:
  1. Mechanism used to finance retirement benefits (risk sharing).
  2. Degree of funding of pension liabilities (financial stability, aggregate savings, growth, capital formation).
  3. Degree of actuarial fairness: (3a) macro feature — long-run financial viability; (3b) micro feature — linkage of benefits to contributions.
- Defined-contribution (DC) plans:
  - Contributions exogenous; benefits endogenous; contributors often bear investment and biometric risk unless annuity purchased.
  - By definition fully funded and actuarially fair in macro and micro senses.
- Defined-benefit (DB) plans:
  - Benefits exogenous; sponsor contributions endogenous; sponsor absorbs biometric and financial risk.
  - Can be funded or unfunded; may be microeconomically actuarially fair/unfair and macroeconomically balanced/unbalanced.
- Cross-country notes:
  - Chile, El Salvador, Mexico and Peru abolished DB components; majority retirement incomes come from mandatory DC pensions.
  - Lithuania and Hungary: less than 30 percent of retirement income for retirees today comes from financial assets in individual accounts.

### Assets, liabilities, and risk exposures
- Pension liabilities:
  - Two main forms: biometric (largely longevity) and financial guarantees.
  - Longevity liabilities typically perpetuity coupons (nominal or indexed), exposing providers to longevity, interest rate, inflation, and wage risk.
  - Financial guarantees include minimum interest returns, guaranteed minimum returns with bonuses, hybrid index-linked guarantees.
- Risk sharing via product design:
  - Lump sums and phased withdrawals transfer longevity and investment risk to retiree.
  - Immediate premium nominal perpetuities transfer only inflation risk to retiree.
  - With-profit perpetuities share investment risk.
  - Term annuities shift tail longevity and investment risk toward end of life.
  - Longevity sharing perpetuities re-price annuities according to pool mortality experience.
- Risk sharing via assets/instruments:
  - CPI-indexed government bonds share inflation risk with Government and future taxpayers.
  - Mortality-indexed instruments share longevity risk with issuer.
  - Interest rate swaps/derivatives share risk with financial counterparties.

### Scale and cross-country statistics (preserved figures)
- OECD private pension plan assets reached US$18 trillion in 2007.
- U.S. pension market accounts for 58 percent of total assets.
- Total pension funds assets grew on average 9 percent per year in 2003–2007.
- OECD pension assets represent 75 percent of area GDP (2007).
- Latin America (June 2008) total assets of private pensions amounted to US$283 billion.
- Latin American pension assets grew at an annualized value of 22 percent in 2003–2008.
- Latin American countries invest on average 20 percent of their assets abroad in foreign currency denominated assets.
- Asset allocation patterns:
  - In 13 out of 22 OECD countries (as of December 2007), over 50 percent of assets were invested in bonds; around 60 percent of these bond investments were in government bonds.
  - Equity investment averages: 30 percent of assets in OECD countries and 15 percent in Latin American countries.
  - U.S. public plans reported on average 60 percent of assets in equities.

### Dutch pension plans and Euro effect
- Dutch pension plans: on average more than 80 percent of assets invested in instruments issued by foreign entities; nearly 40 percent of these assets in currencies other than the Euro.

### Use of derivatives and documented exposures
- Derivatives used to hedge interest rate, FX, longevity risk, and risks associated with financial guarantees.
- Examples of U.S. pension funds buying "equity" tranches of CDOs:
  - New Mexico Investment Council: US$522 million for 3 percent of its total fund
  - General Retirement System of Detroit: $38.8 million
  - Teachers Retirement System of Texas: $62.8 million
  - CalPERS: US$541 million
- Over a decade, U.S. pension funds and endowments bought 7 percent of all the "toxic waste" investment banks and hedge funds offered.

### Insurance sector size, balance-sheet patterns and gearing
- Total assets of insurers worldwide estimated by Swiss Re at around $18 trillion at end-2007.
- Insurance assets are overwhelmingly marketable securities; life insurers’ assets predominantly local currency.
- Reinsurance: recognized as reduction in liabilities and reinsurance recoverable as asset; some jurisdictions require reinsurer collateral.
- Typical balance-sheet (illustrative figures):
  - Liabilities: Unit-linked reserves 100; Reserve for non-life risks 50; Reserve for life risks 200; Reserve for guarantees 50; Margin for solvency (capital) 30; Total 430.
  - Assets: Unit-linked assets 100; Bonds 180; Equities 50; Cash and other assets 100; Total 430.
- Gearing:
  - Non-life insurers: assets on average only 2.5 times equity.
  - Insurance sector as a whole: assets on average 8 times equity.
  - Life insurers with savings and investments have much higher gearing.

### Accounting and solvency frameworks
- No global standards for insurance accounting or minimum solvency standards; IFRS 4 covers financial instruments and disclosures but not yet insurance contracts.
- IASB Insurance Contracts Phase II expected final standard in 2011 (as stated in source).
- Most insurers classify investments as Available for Sale under IAS 39.
- Europe uses Embedded Value (EV) and Market Consistent EV (MCEV); not used in United States.
- IAIS developing solvency assessment principles but without detailed standards equivalent to Basel II.

### Sources of vulnerability (pensions)
- Three major sources:
  1. Asset and liability shocks.
  2. Shocks to income statement due to decreased investment income.
  3. Shocks to contributions due to economic slowdown.
- Solvency and fiscal implications for DB plans (or DC with guarantees) and household/fiscal implications for DC plans.

### Asset shocks—pension losses (preserved figures)
- Private pensions in OECD countries reported US$4 trillion losses in asset values in the first 10 months of 2008.
- Pension funds in OECD countries experienced on average a negative return of nearly 20 percent in nominal terms (22 percent in real terms) since the beginning of the year.
- Most loss accounted for by U.S. pension funds: US$2.2 trillion out of the total OECD loss of 3.US$3 trillion (source text includes typographic inconsistency "3.US$3 trillion").
- Absolute losses: United Kingdom US$0.3 trillion; Australia US$0.2 trillion.
- Including other private pension assets (e.g., IRAs), the loss increases to about US$5 trillion.
- Pension plans of corporations in major stock indices lost around US$1 trillion in asset values between 2007 and the first months of 2009.
  - S&P500 corporate pension assets: peak accounting valuation US$2 billion in June 2007 down 42 percent as of March 2009 → change of US$870 billion.
  - FTSE350 peak-to-trough assets decreased by 26 percent, or US$110 billion.
  - EUR STOXX50 peak-to-trough assets decreased by 26 percent, or US$75 billion.
- OECD Global Pension Statistics used for pension fund returns (asset-weighted average).

### Asset shocks—insurance sector losses and writedowns (preserved figures)
- IMF estimates potential writedowns by insurance companies on holdings of loans and securities originated in the United States, Europe and Japan at $301 billion; total end-2007 equity estimated at $2.2 trillion.
- Swiss Re estimated life companies’ equity fell by between 15 percent and 20 percent up to Q3:2008.
- Swiss Re estimated non-life companies’ total equity reduced by between 10 percent and 15 percent up to Q3:2008.
- European Central Bank estimated fall in major insurance companies’ equity in the euro area at 17 percent (period up to Q3:2008).
- Total announced losses by insurers to date are around $225 billion; half related specifically to CDS contracts.
- Capital raised by insurance companies to date: about $125 billion (bulk for AIG).
- Summary table (rounded figures from source):
  - losses worldwide 225.6; capital 125.9
  - Americas losses 192.5; capital 113.6
  - Europe losses 31.6; capital 12.3
  - Asia losses 1.4; capital 0.0
- Major firm-level announced losses and capital (selected):
  - American International Group: loss 87.0; capital 91.8
  - Ambac Financial Group: loss 12.1; capital 1.4
  - MBIA: loss 5.6; capital 1.0
  - Swiss Re: loss 6.4; capital 2.6
  - Aegon NV: loss 7.9; capital 4.1
  - Allianz: loss 7.3; capital 2.0
- IAIS surveys: holdings of ABSs at most 2 percent of total insurance sector assets in any jurisdiction when crisis broke.
- Fitch estimates U.S. life companies’ holdings of U.S. sub-prime and Alt-A paper at $140 billion or 2.8 percent of total (end-2007) assets.
- Fitch estimates combined CMBS and direct mortgage loan exposure of U.S. life insurers at $474 billion (10 percent of total assets but 19 percent of the assets whose risk is borne by the insurer).
- Total life insurance reserves relating to annuities in the U.S.: $2.5 trillion (representing some two thirds of total reserves).

### Liability shocks and valuation effects (preserved figures)
- Accounting liabilities for pension plans in major indices (effect of yield curve changes):
  - S&P500 accounting liabilities increased from a minimum of US$1.5 trillion to US$2.2 trillion by the end of 2008.
  - FTSE350 accounting liabilities increased from a minimum of US$300 billion to US$400 billion by March 2009.
  - EUR STOXX50 accounting liabilities increased from a minimum of US$220 billion to US$300 billion by January 2009.
  - Overall liabilities increased by more than US$800 billion over the same period.
- Liability changes table (Major Stock Indices):
  - FTSE350 Max (US$ million) 394 on 03/06/09; Min (US$ million) 303 on 10/14/08.
  - S&P500 Max (US$ million) 2,187 on 12/30/08; Min (US$ million) 1,458 on 10/17/08.
  - EURSTOXX50 Max (US$ million) 302 on 01/02/09; Min (US$ million) 219 on 10/14/08.
  - TOT Max (US$ million) 2,827 on 01/14/09; Min (US$ million) 2,002 on 10/17/08.
- Life insurers vulnerable to falling interest rates, high market volatility, and falls in equity or bond markets driven by increased spreads rather than changes in risk-free rate.
- Policyholder behavior risks: worsening persistency, exercise of guarantee options, decline in new business (United Kingdom new business down 13 percent in 2008; France down 11 percent in 2008).

### Insurance liquidity and market access risks
- Structural low exposure to liquidity risk because premium funded and assets predominantly marketable, but exposures exist from:
  - collateral calls in derivative business and securities lending;
  - market liquidity risks (investments in ABSs);
  - rising claims temporarily overwhelming liquidity (AIG example).
- Reinsurance markets remain available; insurance-linked securitization markets slowed; life risk securitization halted.
- Non-life combined ratio rose to as much as 105 percent in 2008 compared with 96 percent in 2007 in the United States.
- Directors and Officers (D&O) liabilities estimates around $12 billion but rising.

### Transmission channels to the rest of the economy (VI)
- Contractual savings institutions act as shock absorbers due to long-term liabilities; sponsors can amortize unfunded DB liabilities.
- Four distinct transmission channels:
  1. Surplus volatility of DB plans → sponsor balance sheets.
  2. Asset volatility → household balance sheets.
  3. DB and DC plans with implicit/explicit government guarantees → government balance sheets (fiscal channel).
  4. Plan investing activities → rest of financial sector and economy.
- DB vs DC:
  - DC shifts future economic risk to pensioners.
  - DB shifts adverse economic environment risks to contributors (younger generation).
  - Recommends combination of DB and DC to diversify macro risks across and within generations.

### Valuation rules, procyclicality and heterogeneity
- No accepted international standard for DB valuation; multiple funding/accounting standards exist.
- Smoothing of returns permitted in many jurisdictions; smoothing reconsidered as relief to diminish sponsor contribution volatility.
- U.S. within-country heterogeneity:
  - Costing methods: projected unit methods common for ERISA corporate plans; entry age normal for government plans; aggregate cost method recognizes no unfunded liability.
  - Discount factors: ERISA corporate plans use a two year average simplified yield curve based on AA corporate bonds; U.S. Public plans typically use a fixed rate set on average at 8 percent.
  - Accounting standards: FASB (FAS 87) for corporate plans; GASB for public plans.
- Market-based valuation (IAS19/FRS17/FAS87/SFAS158 variations) can generate volatility in sponsors’ balance sheets and income statements and may be procyclical.

### Changes in accounting funding levels (major indices) — preserved figures
- FTSE350 funding ratios:
  - Improved until end-2008 despite large asset drops in H2 2008.
  - Driven by increase of 60 bps in corporate yields between September and October 2008 and increase of more than 100 bps in index-linked gilt yields between September and December 2008.
  - Trend reversed first 4 months of 2009: funding ratios decreased from 110 percent to 84 percent by beginning of March.
- S&P500 and EUR STOXX50 corporate plans sharply deteriorated since late 2008.
- Cumulative market volatility (Sep 2008–Mar 2009) lowered funding ratios from a peak of 110 percent to 66 percent between September 2008 and March 2009.
- Table 5 key figures (Funding Ratio Changes):
  - Max (US$ million): FTSE350 115; S&P500 115; EURSTOXX50 103; TOT 110
    - Dates of maxima: FTSE350 10/14/08; S&P500 09/20/07; EURSTOXX50 10/14/08; TOT 09/20/07
  - Min (US$ million): FTSE350 84; S&P500 61; EURSTOXX50 70; TOT 66
    - Dates of minima: FTSE350 03/06/09; S&P500 03/05/09; EURSTOXX50 03/09/09; TOT 03/06/09
  - Source: Calculations on Hewitt data.

### Public plans (U.S. state and local) — preserved figures and scenarios
- State and local DB plans average 60 percent of assets in equities.
- Financial crisis reduced value of equities in state and local DB plans by about US$1 trillion.
- Average DB plan asset allocation: 60 percent equities, 30 percent fixed income, 10 percent other assets.
- Average funding ratio of state and local plans was 87 percent in 2007.
- By October 2008, funding ratio would have declined to 65 percent if assets valued at market values (Munnell et al. (2008)).
- Smoothing: averaging market value of assets over five years.
- Projections (liabilities assumed to grow at 5.7 percent per year):
  - Optimistic scenario (assets return to 2007 values): funding ratios projected to increase to 75 percent in 2013.
  - Pessimistic scenario (asset values remain at end-2008 level): funding ratios expected to decrease to 59 percent.

### DC plans, household balance sheets and Latin America multi-fund performance (preserved figures)
- Share of household financial assets in pension funds (OECD examples through 2006):
  - The Netherlands 48 percent; Switzerland 34 percent; United States 28 percent; Norway 28 percent; Sweden 21 percent.
  - Several countries 10–20 percent (examples: Hungary and Japan); rest of OECD < 10 percent.
- Latin America multi-fund real returns (selected):
  - Mexico Sep. 07–Sep. 08: -5.6 percent; Sep. 08: -2.4 percent.
  - Chile Sep. 07–Sep. 08: -16.4 percent; Sep. 08: -7.2 percent.
  - Peru Sep. 07–Sep. 08: -17.5 percent; Sep. 08: -4.0 percent.
- In mandatory DC systems, losses amount to 30–50 percent in aggressive funds and 0–5 percent in conservative funds (exceptions where conservative funds had large equity components: Hungary, Peru, Estonia, Lithuania).

### Pension expenses and aggregate private pension losses (preserved figures)
- Estimates as of October 2008: pension expenses among constituents of the S&P500 averaged US$35 billion for 2009 after a 20 percent fall in the index.
- Aggregate private pensions in OECD countries reported US$4 trillion in losses in asset values in first 10 months of 2008; including IRAs/voluntary plans increases loss to about US$5 trillion.
- Aggregate accounting surpluses for corporate plans in S&P500, STOXX50 and FTSE350 decreased from US$246 billion on 09/20/07 to minus US$860 billion on 03/02/09.
- Relative change in aggregate funding ratios: from 110 percent to 67 percent.

### Fiscal implications, guarantees and contingent liabilities (preserved figures)
- Minimum pension guarantees:
  - Almost all countries have a minimum pension guarantee.
  - Minimum pension guarantees on average 30 percent of average earnings.
  - Mexico example: workers at time of 1997 reform may elect pension under old PAYG if new DC pension is lower.
- Potential government costs from guarantee fund deficits and contingent liabilities:
  - United States: estimated potential costs amount to 0.4 percent of GDP.
  - United Kingdom: estimated potential costs amount to 0.1 percent of GDP.
- Implicit pension debt (IPD) used as rough indicator of accrued pension system liabilities; sensitive to discount factor.

### Trading patterns, herding, and market stability
- Evidence of contemporaneous and dynamic herding in Chilean funds for certain asset classes.
- Momentum strategies documented (Chile): buying government bonds and foreign mutual funds when lagged returns positive; buying domestic equity when lagged returns negative (contrarian).
- Momentum and herding can amplify price volatility when assets under management are large.

### Insurance sector transmission to real economy
- Primary insurer exposure to banks via market securities in investment portfolios.
- Cross-sector risks from group-level exposures, common management failings, intra-group support pressures.
- Insurance-Linked Securities (ILS) outstanding at end-2007: $39 billion (around half life insurance risks).
- Non-life failures can reduce risk management capacity (example: HIH failure in Australia 2000–2001).
- Life company problems can reduce annuitant income and policyholder protection, and cause substitution to other savings markets.
- Policyholder protection arrangements vary; resolution procedures often underdeveloped.
- Direct government support historically limited but has occurred (examples: Australia after HIH; U.S. AIG support).

### Policy conclusions and recommendations (preserved points)
Findings:
- Recent turmoil generated large losses in insurance and pension industries.
- Large unfunded liabilities created in DB plans; recognition will occur over next few years in jurisdictions using smoothing techniques.
- Private pensions in OECD countries reported US$4 trillion in asset value losses in first 10 months of 2008; including IRAs increases loss to about US$5 trillion.
- Aggregate accounting surpluses in corporate plans across S&P500, STOXX50, FTSE350 fell from US$246 billion on 09/20/07 to minus US$860 billion on 03/02/09; funding ratios from 110 percent to 67 percent.
- Mark-to-market losses in DC plans significant in aggressive funds (30–50 percent) and small in conservative funds (0–5 percent), with notable exceptions.

Policy recommendations and IMF roles:
- Address heterogeneous valuation, funding, accounting and disclosure standards of pension plans and insurance companies.
- Tackle procyclicality and design countercyclical policy responses.
- Help countries monitor contagion channels to the real economy and the financial sector, including the fiscal channel.
- Strengthen group-wise supervision, especially for insurance companies; assess group risks and undertake consolidated supervision where appropriate.
- For DB plans:
  - Recognize that minimum funding target rules and market-based valuation methods amplify contagion by imposing procyclical targets.
  - Use countercyclical policy responses to relax regulatory requirements temporarily without endangering long-term viability.
- For DC plans:
  - Mitigate wealth-effect and annuitization-risk transmission channels by:
    - Balancing disclosure frequency and asset valuation to reduce household rebalancing/consumption effects.
    - Re-evaluating default investment option design.
    - Considering regulatory requirements for investing cash balances in long-term bonds and/or deferred annuities toward retirement.
    - Revisiting the role of lifetime minimum rate of return guarantees.
- For fiscal risks:
  - Monitor heterogeneous systems of government guarantees, safety nets and eligibility rules.
  - Track potential costs from guarantee fund deficits and contingent liabilities (examples cited: 0.4 percent of GDP for United States; 0.1 percent of GDP for United Kingdom).

### Insurance regulation, group supervision and crisis management
- Credit risk transfers from banks to insurers (monolines and AIG) exceeded capacity of insurance regulatory frameworks.
- Insurance regulation should address concentrations of banking-type risks and strengthen group supervision and consolidated assessment.
- Only Europe (Solvency II) has prospect of insurance standards akin to Basel II in foreseeable future; absence of global standard impairs comparability and transparency.
- Recommend revisiting resolution and crisis management frameworks for insurance, powers to intervene, and clarity on circumstances for central bank or government support.
- Consider supervising large insurance groups more similarly to major banking groups: colleges of regulators, consolidated supervision, global reporting and stress testing, and inclusion in macroprudential frameworks.

### U.S. accounting for DB pension plans (FAS 87) — preserved points
- FAS 87 introduced in "1986" standardized actuarial assumptions for valuing pension liabilities and reporting net pension assets/liabilities on sponsor balance sheet.
- FAS 87 reports only net difference between pension assets and liabilities.
- Net periodic pension cost (NPPC) equals annual accrued costs minus "expected return on plan assets."
- Expected return = assumed long-run rate of return on plan assets × market related value (MRV) (either fair market value or 5-year moving average).
- Because assumed return is not risk adjusted, actuary guided to ignore underlying portfolio risk when assuming expected return.
- Consequence: actual return on pension plan assets does not show through sponsor’s financial statement.
- Empirical note: "The average plan in the United States uses 9 percent as expected return on assets and uses 7 percent to discount liabilities."
- Accounting treatment considered principal cause of equity bias (60 percent on average) of U.S. DB pension plans.

*Source: IMF staff working paper _wp09151.*

### References..............................................................................................................

### References

### Purpose and scope
- The paper discusses they key sources of vulnerabilities and transmission channels to the rest of the financial sector and real economy for the pension and insurance sectors associated with the global financial crisis of 2008.
- Given the heterogeneity of insurance and pensions arrangements, the objective of the paper is not to quantify the impact of the crisis on pension and insurance balance sheets.
- Given its findings, the paper also aims at drawing related policy implications.

### Geographic and institutional focus
- The paper focuses on OECD and Latin American countries as representative of a wide range of insurance and pension arrangements and for which data is more readily available.
- Within these countries, the paper notes substantial heterogeneity in:
  - pension arrangements covering mandatory and voluntary plans, specialized pension annuity companies, pure asset management pension plans, and other forms of plans providing a wide array of financial and biometric guarantees;
  - actuarial, solvency and accounting standards (even within countries);
  - insurance sector structures, including large companies, part of large financial groups, insuring a wide array of risks and providing different forms of financial guarantees.
- The paper observes a variety of approaches to measuring, managing and regulating insurance company solvency, and notes ongoing efforts (including the recently-agreed European Solvency II legislation) to develop more risk-based international standards.

### Analytical structure
- Section II discusses the institutional role of pension funds and insurance companies.
- Section III discusses the key pensions and insurance characteristics highlighting their differences and similarities.
- Section IV discusses the nature of the assets and liabilities in these two industries.
- Section V discusses the sources of vulnerabilities for insurance companies, defined benefit (DB) and defined contribution (DC) pension plans.

*Source: _wp09151 - References*

### Section VI discusses the key differences in risk sharing properties of insurance and pension

### _wp09151 - Section VI discusses the key differences in risk sharing properties of insurance and pension

### Role of pension plans and insurance companies
- Contractual savings (pension plans and life insurance companies) are important vehicles for channeling personal sector savings.
- Life insurers increasingly engage in long term contractual savings business, including savings for retirement, and are major providers of annuities in many markets.
- Contractual savings enable households to smooth income and consumption over the lifecycle; absence of such products could raise precautionary savings and affect consumer behavior and government finances.
- Contractual savings promote more efficient risk diversification by the financial sector:
  - Increase demand for long-term financial assets, potentially shifting intermediation from banks to capital markets.
  - Associated with an increase in stock market depth where corporates rely more on capital market financing.
  - Associated with an increase in bond market depth where corporates rely more on bank financing.
  - Pension plans lead to increased stock market depth and liquidity where pension contributions are mandatory; these effects are less clear where contributions are primarily voluntary.
- Contractual savings can improve mitigation of firms’ and banks’ financial risks by increasing availability of long-term funds:
  - In capital market based financial systems, growth of financial savings and portfolio choices are associated with increased debt finance; contractual savings hold larger shares of equities and firms substitute equity for short-term debt.
  - In bank-based systems, growth of contractual savings is associated with increased debt finance and increased debt maturity; contractual savings provide liquidity to banks and encourage long-term loan supply.
- Insurance companies help other sectors manage risk by transferring risks from corporate and household sectors; reinsurance enables primary insurers to manage catastrophic risk.

### Key pensions and insurance characteristics
- Private pension plan managers vary widely in corporate form: separate corporate managers, life insurance companies, multi- or single-employer plans, banks, specialized asset managers, and specialized pension annuity providers.
- Three key dimensions for analyzing private pension plans:
  1. Mechanism used to finance retirement benefits (relevant for risk sharing properties).
  2. Degree of funding of pension liabilities (relevant for financial stability, aggregate savings, growth, and capital formation).
  3. Degree of actuarial fairness (relevant for financial stability and labor market efficiency), with two features:
     - (3a) Macroeconomic feature: long-run financial viability of the plan.
     - (3b) Microeconomic feature: extent to which benefits are linked to contributions (“intergenerational fairness”).
- Defined-contribution (DC) plans:
  - Contributions are exogenous and benefits are endogenous; value of retirement benefits depends on level and timing of contributions and compounded rate of return in individual accounts.
  - Contributors often responsible for choosing plan managers, asset allocation and fully bear investment risk and biometric risk unless an annuity is purchased.
  - Focus of analysis is at the household level; fiscal consequences arise from explicit or implicit government guarantees in mandatory systems.
- Defined-benefit (DB) plans:
  - Benefits are exogenous and sponsor contributions are endogenous; sponsor underwrites pension liability and fully absorbs biometric and financial risk.
  - Focus of analysis is on solvency of pension firms and impact on sponsor balance sheet; if sponsor is government, solvency analysis equates to fiscal/debt stability analysis.
- Funding and actuarial fairness interrelations:
  - DC plans are by definition fully funded and actuarially fair in both macro and micro senses.
  - DB plans can be funded or unfunded and have benefit formulas that are microeconomically actuarially fair or unfair and be macroeconomically balanced or unbalanced.
- Cross-country observations:
  - In Eastern Europe and Central Asia (except Kazakhstan) that introduced DC plans, countries also maintained a defined-benefit system; in Lithuania and Hungary, less than 30 percent of retirement income for retirees today comes from financial assets in individual accounts.
  - Chile, El Salvador, Mexico and Peru abolished their DB components and majority of retirement incomes comes from mandatory DC pensions.
  - Except for Latin American and Eastern European countries, most countries have both DB and DC plans within private pensions.
- Insurance sector risk allocation:
  - In non-life insurance, underwriting and investment losses fall to shareholders; underwriting profit (premium income less claims and expenses) and investment income cushion claims spikes.
  - In life insurance, many products are “unit-linked” or “market-linked” where investment risk falls wholly or partially to policyholder; many companies continue to offer guarantees (minimum returns, fixed annuity rates, contractual withdrawal options) transferring risk back to insurers.
- Legal, regulatory and accounting requirements for life insurance and pension funds are separate and distinct; integrated regulators may supervise both sectors. Proposals exist to harmonize standards (e.g., long-term EU objective applying Solvency II to pension funds). Accounting, solvency and financial disclosure standards vary across countries and within countries.

### Nature of assets and liabilities; risk exposures and sharing channels
- Pension plans and insurance companies are vulnerable to shocks on both asset and liability sides and to income statement pressures during economic slowdowns.
- Liability structures:
  - Insurance companies: liability structure is generally more complex than pension plans; insurers insure a wider range of risks.
  - Pension plans: typically insure primarily financial and biometric risks; asset-liability management is critical for solvency.
- Pension liabilities:
  - Two main forms: liabilities from insurance of biometric risks (largest component often longevity insurance) and liabilities from insurance of financial guarantees.
  - Longevity liabilities typically take the form of perpetuity coupons, nominal or indexed to prices, wages or combination, exposing providers to longevity, interest rate, inflation and wage risk.
  - Financial guarantees (more common in DB and hybrid plans, less common in DC plans) include minimum interest rate returns on pension policies, guarantees of minimum returns with sharing of excess returns through bonuses, or hybrid plans guaranteeing index-linked returns.
- Risk sharing via retirement product diversification:
  - Lump sums and phased withdrawals transfer longevity and investment risk to the retiree.
  - Immediate premium nominal perpetuities transfer only inflation risk to the retiree.
  - With-profit perpetuities share investment risk.
  - Term annuities shift the tail of longevity risk and investment risk toward the end of life to retirees.
  - Longevity sharing perpetuities re-price annuities according to mortality experience of the pool, sharing longevity risk with retirees.
  - Heterogeneity of retirement products and disconnection between accumulation and decumulation in mandatory DC pensions raise concerns about households’ ability to hedge annuitization risk.
- Risk sharing via assets and financial instruments:
  - Investing in CPI-indexed government bonds shares inflation risk with the Government and future taxpayers.
  - Investing in mortality-indexed instruments shares longevity risk with the issuer.
  - Investing in interest rate swaps or other derivatives shares risks with financial counterparts.
- Comparability and scale of pension assets:
  - Cross-country comparisons of pension liabilities are impaired by country-specific valuation assumptions; comparison of assets under management is easier.
  - OECD private pension plan assets reached US$18 trillion in 2007, representing around 65 percent of the total private pension assets arrangements.
  - The U.S. pension market accounts for 58 percent of total assets but its share has been decreasing due to faster growth in other OECD pension funds.
  - Total pension funds assets grew on average 9 percent per year in the period 2003–2007.
  - OECD pension assets represent 75 percent of area GDP (2007).
  - In Latin America (June 2008) total assets of private pensions amounted to US$283 billion.
  - Latin American pension assets grew at an annualized value of 22 percent in the period 2003–2008, double the average growth in OECD countries.
- Asset allocation patterns:
  - Fixed income assets represent on average the largest share of pension fund assets.
  - As of December 2007, in 13 out of 22 OECD countries with available information, over 50 percent of assets were invested in bonds, and around 60 percent of these bond investments were in government bonds.
  - Pension plans in Latin America on average had a similar exposure to fixed income instruments.
  - Equity investment averages: 30 percent of assets in OECD countries and 15 percent of assets in Latin American countries.
  - U.S. public plans are reported to have on average 60 percent of assets in equities.
  - Latin American countries invest on average 20 percent of their assets abroad in foreign currency denominated assets.

*Source: _wp09151 - Section VI discusses the key differences in risk sharing properties of insurance and pension*

### introduction of the Euro which eliminated within area currency risk. Dutch pension plans

### _wp09151 - introduction of the Euro which eliminated within area currency risk. Dutch pension plans

### Asset allocation of pension plans
- Dutch pension plans have on average the most diversified portfolios with more than 80 percent of assets invested in instruments issued by foreign entities and nearly 40 percent of these assets in currencies other than the Euro.
- OECD private pension plans (2006) asset categories noted in the source include: Bills and bonds, Shares, Mutual funds (1), Other assets (2).
- Latin American pension plans (June 2008) average asset allocation (Figure 6) numeric breakdown:
  - 36.4
  - 15.4
  - 8.4
  - 14.5
  - 3.2
  - 20.9
  - 1.2

### Use of derivatives and investment practices
- Pension plans use derivatives to hedge:
  - interest rate risk,
  - FX risk,
  - longevity risk,
  - risks associated with financial guarantees.
- Derivative use is of particular concern in OECD countries, especially among DB plans or plans with foreign currency exposure and as a way to increase the duration of assets.
- Derivative investment may also be speculative, part of carving out strategies or alpha and beta portfolio management strategies.
- Examples of U.S. pension funds purchasing the last-to-be-paid "equity" tranches of CDOs:
  - New Mexico Investment Council: US$522 million for 3 percent of its total fund
  - General Retirement System of Detroit: $38.8 million
  - Teachers Retirement System of Texas: $62.8 million
  - CalPERS: US$541 million
- Over a decade, U.S. pension funds and endowments bought 7 percent of all the "toxic waste" investment banks and hedge funds had on offer because of high returns.
- The use of derivatives by pension funds is largely undocumented in general.

### Insurance sector structure and balance-sheet characteristics
- Total assets of insurers worldwide are estimated by Swiss Re at around $18 trillion at end-2007.
- Insurance company assets are overwhelmingly marketable securities; the majority are invested in high quality assets and are often classified as Available for Sale under IFRS.
- Life insurers’ assets are predominantly local currency; non-life and especially reinsurance companies tend to have a wider range of non-local assets.
- Reinsurance effects:
  - Purchase of reinsurance creates a potential claim on the reinsurer in case of a claim by the underlying insured party.
  - Reinsurance is usually recognized as a reduction in liabilities and reinsurance recoverable as an asset.
  - In some jurisdictions, primary insurers are required to hold collateral from reinsurers as a condition of recognizing the recoverable.
- Insurance company assets composition and risk management:
  - Assets are mostly marketable securities with some alternative investments and limited structured finance.
  - Derivatives are used, particularly in life insurance and reinsurance, to manage risks.
  - Some insurers have been large writers of credit derivatives (examples given: monoline insurers and AIG).
  - Asset-liability matching (ALM) is a key consideration for long-duration liabilities (e.g., annuities); many risks cannot easily be hedged.
- Insurance company gearing:
  - Non-life insurers: assets on average only 2.5 times equity.
  - Insurance sector as a whole: assets on average 8 times equity.
  - Life insurers with savings and investments business have much higher gearing.

### Typical insurance company balance sheet and ALM importance (Box 1)
- Insurance companies differ from banks: funded by premiums rather than borrowings; reserves estimate expected future claims.
- Typical balance-sheet figures presented (Liabilities vs Assets):
  - Liabilities
    - Unit-linked reserves: 100
    - Reserve for non-life risks: 50
    - Reserve for life risks: 200
    - Reserve for guarantees: 50
    - Margin for solvency (capital): 30
    - Total: 430
  - Assets
    - Unit-linked assets: 100
    - Bonds: 180
    - Equities: 50
    - Cash and other assets: 100
    - Total: 430
- Note: In practice, most countries require life and non-life business to be carried out in separate legal entities.

### Accounting and solvency frameworks (Box 2)
- There are no global standards for insurance company accounting and no global framework of minimum solvency (capital) standards, impairing cross-country comparability.
- International Financial Reporting Standards apply to insurers (IFRS 4), but the framework covers mainly financial instruments and disclosures, not yet insurance contracts; previous national standards often continue to apply on the liability side.
- The IASB project, Insurance Contracts Phase II, will introduce a new approach to insurance liabilities, with a final standard due in 2011.
- IAS 39 (Financial Instruments) applies to insurers; most classify investments as Available for Sale—profits and losses are accounted for as equity adjustments and recycled to profit and loss only on sale or impairment.
- Regulators in many countries prescribe their own standards for accounting for regulatory purposes, operating alongside normal accounting standards.
- Europe: Embedded Value (EV) and Market Consistent EV (MCEV) are used to measure economic value and profitability for reporting to investors; EV/MCEV measurement is not used in the United States.
- The International Association of Insurance Supervisors (IAIS) continues to develop principles for solvency assessment but has no detailed standards equivalent to Basel II; consideration is being given to a new common framework for internationally active groups.

### Sources of vulnerability for pension plans (V. SOURCES OF VULNERABILITY)
- Pension plans face three major sources of vulnerabilities:
  - (1) Asset and liability shocks
  - (2) Shocks to the income statement due to decreased investment income
  - (3) Shocks to contributions into the plan as a consequence of an economic slowdown
- These shocks have solvency and fiscal implications for DB plans (or DC with guarantees) and household balance sheet and fiscal implications for DC plans.

*Source: _wp09151 - introduction of the Euro which eliminated within area currency risk. Dutch pension plans (IMF PDF content provided).*

### section VI on contagion channels).

### _wp09151 - section VI on contagion channels

### Asset shocks
- Private pensions in OECD countries reported US$4 trillion losses in asset values in the first 10 months of 2008.
- Pension funds in OECD countries have experienced on average a negative return of nearly 20 percent in nominal terms (22 percent in real terms) since the beginning of the year.
- Most of the loss is accounted for by pension funds in the United States (US$2.2 trillion out of the total OECD loss of 3.US$3 trillion) due to larger than average exposure to equity risk.
- Absolute losses: United Kingdom US$0.3 trillion; Australia US$0.2 trillion.
- Including other private pension assets (e.g., IRAs), the loss increases to about US$5 trillion.
- Pension plans of corporations in major stock indices lost around US$1 trillion in asset values between 2007 and the first months of 2009.
  - S&P500 corporate pension assets: peak accounting valuation US$2 billion in June 2007 down 42 percent as of March 2009 → change of US$870 billion.
  - FTSE350 peak-to-trough assets decreased by 26 percent, or US$110 billion.
  - EUR STOXX50 peak-to-trough assets decreased by 26 percent, or US$75 billion.
- Changes in mandatory DC plans in Latin America (selected examples, balanced funds):
  - Peru: balanced funds decreased 34 percent (in conservative default options balanced funds decreased between 6 percent in Mexico and 34 percent in Peru).
  - Chile: balanced -46.1-23.1 (date 13-Oct).
  - Mexico: balanced -8.3-6 (date 30-Sept).
  - Peru: balanced -47.8-33.9 (date 10-Oct); conservative -14.5.
  - Estonia: balanced -30.5-20.9 (date 15-Oct); conservative -9.7.
  - Hungary: balanced -35 (date 15-Oct); conservative -18.
  - Lithuania: balanced -48.4-32.6 (date 15-Oct); conservative -9.4.
  - Slovak Republic: balanced -12.4-10.3; conservative -2 (date 13-Oct).
- Source for pension fund returns: OECD Global Pension Statistics (asset-weighted average; country list provided in note).

### Insurance sector exposures and losses
- Life and non-life companies face different financial strains: non-life primarily from higher than expected claims; life mainly from market risk.
- Swiss Re estimates falls in investment values had driven a reduction in non-life companies’ total equity by between 10 percent and 15 percent up to Q3:2008.
- IMF estimates potential writedowns by insurance companies on holdings of loans and securities originated in the United States, Europe and Japan at $301 billion; total end-2007 equity estimated at $2.2 trillion.
- Swiss Re estimated total life companies’ equity fell by between 15 percent and 20 percent up to Q3:2008.
- European Central Bank estimated fall in major insurance companies’ equity in the euro area at 17 percent (period up to Q3:2008).
- Total announced losses by insurers to date are around $225 billion; half related specifically to CDS contracts.
- Capital raised by insurance companies to date: about $125 billion (bulk for AIG).
- Table summary (Worldwide / regional):
  - losses worldwide 225.6; capital 125.9
  - Americas losses 192.5; capital 113.6
  - Europe losses 31.6; capital 12.3
  - Asia losses 1.4; capital 0.0
- Major firm-level announced losses and capital:
  - American International Group: loss 87.0; capital 91.8
  - Ambac Financial Group: loss 12.1; capital 1.4
  - MBIA: loss 5.6; capital 1.0
  - Swiss Re: loss 6.4; capital 2.6
  - Aegon NV: loss 7.9; capital 4.1
  - Allianz: loss 7.3; capital 2.0
  - Others listed with specific loss and capital figures in source table.
- Insurer holdings and exposures:
  - IAIS surveys suggested holdings of ABSs were at most 2 percent of total insurance sector assets in any jurisdiction when the crisis broke.
  - Fitch estimates U.S. life companies’ holdings of U.S. sub-prime and Alt-A paper at $140 billion or 2.8 percent of total (end-2007) assets.
  - Fitch estimates combined CMBS and direct mortgage loan exposure of U.S. life insurers at $474 billion (10 percent of total assets but 19 percent of the assets whose risk is borne by the insurer).
- Total life insurance reserves relating to annuities in the U.S.: $2.5 trillion (representing some two thirds of total reserves).
- Total announced losses by insurers to date and capital raising details provided in source Table 3 (Bloomberg).

### Liability shocks (pensions and insurance)
- Valuation of DB liabilities affected by: scope of valuation, costing methods, term structure of discount rates, and local accounting standards — highly heterogeneous across and within countries.
- Accounting liabilities for pension plans in major indices (effect of yield curve changes):
  - S&P500 accounting liabilities increased from a minimum of US$1.5 trillion to US$2.2 trillion by the end of 2008.
  - FTSE350 accounting liabilities increased from a minimum of US$300 billion to US$400 billion by March 2009.
  - EUR STOXX50 accounting liabilities increased from a minimum of US$220 billion to US$300 billion by January 2009.
  - Overall liabilities increased by more than US$800 billion over the same period.
- Liability changes table (Major Stock Indices):
  - FTSE350 Max (US$ million) 394 on 03/06/09; Min (US$ million) 303 on 10/14/08.
  - S&P500 Max (US$ million) 2,187 on 12/30/08; Min (US$ million) 1,458 on 10/17/08.
  - EURSTOXX50 Max (US$ million) 302 on 01/02/09; Min (US$ million) 219 on 10/14/08.
  - TOT Max (US$ million) 2,827 on 01/14/09; Min (US$ million) 2,002 on 10/17/08.
- Life insurers:
  - Vulnerable to falling interest rates (reducing returns on assets/the discount rate on liabilities), high market volatility (increasing cost of guarantees), and falls in equity or bond markets driven by increased spreads rather than changes in the risk-free rate.
  - Guarantees (e.g., on variable annuities) have become more costly to hedge; guarantees typical on VA products include guaranteed minimum account value or minimum income on annuitization and guaranteed minimum withdrawal benefits.
  - Policyholder behavior risks: worsening persistency (surrenders), exercise of options on guarantees, and decline in new business (United Kingdom new business down 13 percent in 2008; France down 11 percent in 2008).

### Insurance liquidity, market access and product exposures
- Insurers have structural low exposure to liquidity risk because they are premium funded and assets are predominantly marketable; however exposures exist from:
  - collateral calls in derivative business and securities lending;
  - market as opposed to funding liquidity (e.g., investments in ABSs);
  - rising claims temporarily overwhelming liquidity (AIG experience).
- Reinsurance markets remain available; insurance-linked securitization markets have slowed and life risk securitization has halted alongside the general fall in ABS markets.
- Non-life sector specifics:
  - Combined ratio rose to as much as 105 percent in 2008 compared with 96 percent in 2007 in the United States because of storm-related claims and credit losses.
  - Credit protection and trade credit insurers, and U.S. mortgage insurance companies, face further losses.
  - Directors and Officers (D&O) liabilities estimates around $12 billion but rising; Madoff-related cases expected to increase claims.

### VI. Risk sharing and transmission channels to the rest of the economy
- Contractual savings institutions act as shock absorbers due to long-term nature of liabilities (pensions illiquid until retirement; sponsors can amortize unfunded DB liabilities).
- Distinct transmission channels for DB and DC plans:
  1. Impact of surplus volatility of DB plans on the balance sheet of sponsors.
  2. Impact of asset volatility on the balance sheet of households.
  3. Financial stability impact of DB and DC plans with implicit or explicit government guarantees on the balance sheet of the government.
  4. Impact on the rest of the financial sector and economy from plan investing activities.
- DB versus DC risk allocation:
  - DC plans (contribution rate constant) shift future economic risk to pensioners.
  - DB plans (exogenous replacement rate) keep benefits constant, shifting adverse economic environment risks to contributors (younger generation).
  - Recommended pension system design: combination of both DB and DC plans to diversify macro risks across and within generations.
- Valuation rules heterogeneity and consequences:
  - No accepted international standard for valuation of DB assets and liabilities; multiple standards for funding and accounting purposes.
  - Smoothing of asset returns is permitted in many jurisdictions; smoothing is being reconsidered as a relief measure to diminish volatility of sponsor contributions.
  - In the United States, valuation heterogeneity within country:
    - Costing methods: projected unit methods common for ERISA-covered corporate plans; entry age normal for government plans; aggregate cost method recognizes no unfunded liability.
    - Discount factors: ERISA corporate plans can use a two year average simplified yield curve based on AA corporate bonds; U.S. Public plans typically use a fixed rate set on average at 8 percent.
    - Accounting standards: FASB (FAS 87) for corporate plans; GASB for public plans—FAS 87 linked to excessive equity investment in U.S. DB plans (average 60 percent equities) because actuaries assume long rate of return on DB plan assets, such rate may not reflect portfolio risk, and pension asset volatility is smoothed in sponsor income statements.
- Market-based valuation and procyclicality:
  - Application of IAS19 (FRS17, FAS87, SFAS158 variations) and market valuation principles generate volatility in sponsors’ balance sheets and income statements.
  - Removal of smoothing options could force sponsors to inject extra contributions in bad states without encouraging buffer build-up in good states and could lead to procyclical behavior by pension plans.
- Funding ratios of corporate plans worsened in the second half of 2008 and beginning of 2009 (detailed asset and liability changes provided above).

*Source: _wp09151 - section VI on contagion channels).*

### 2009. Figure 12 reports the changes in the funding levels for accounting purposes of pension

### _wp09151 - 2009. Figure 12 reports the changes in the funding levels for accounting purposes of pension

### Changes in accounting funding levels of corporate pension plans (major stock indices)
- FTSE350 accounting funding ratios:
  - Improved until the end of 2008 despite large asset drops in H2 2008.
  - Improvement driven by: an increase of 60 bps in corporate yields between September and October 2008 and an increase of more than 100 bps in index-linked gilt yields between September and December 2008.
  - Trend reversed in the first 4 months of 2009: funding ratios decreased from 110 percent to 84 percent by the beginning of March.
- S&P500 and EUR STOXX50 corporate plans:
  - Sharply deteriorated since the last part of 2008.
- Cumulative market volatility (Sep 2008–Mar 2009):
  - Lowered funding ratios from a peak of 110 percent to 66 percent between September 2008 and March 2009 (Table 5).

Key figures from Table 5 (Funding Ratio Changes in Corporate Plans, Major Stock Indices):
- Max (US$ million): FTSE350 115; S&P500 115; EURSTOXX50 103; TOT 110
  - Dates of maxima: FTSE350 10/14/08; S&P500 09/20/07; EURSTOXX50 10/14/08; TOT 09/20/07
- Min (US$ million): FTSE350 84; S&P500 61; EURSTOXX50 70; TOT 66
  - Dates of minima: FTSE350 03/06/09; S&P500 03/05/09; EURSTOXX50 03/09/09; TOT 03/06/09
- Source: Calculations on Hewitt data.

### Public pension plans (U.S. state and local) and projections
- Equity exposure and leverage:
  - State and local authority DB plans average 60 percent of assets in equities.
  - The financial crisis reduced the value of equities in State and local authorities’ DB plans by about US$1 trillion.
  - Average DB plan asset allocation: 60 percent in equities, 30 percent in fixed income, and 10 percent in other assets.
- Funding ratios and smoothing:
  - Average funding ratio of state and local plans was 87 percent in 2007.
  - By October 2008, funding ratio would have declined to 65 percent if assets were valued at market values (Munnell et al. (2008)).
  - Smoothing: plans smooth gains and losses by averaging the market value of assets over a five year period.
- Projected scenarios for state and local plans (liabilities assumed to grow at 5.7 percent per year):
  - Optimistic scenario (assets return to 2007 values): funding ratios projected to increase to 75 percent in 2013.
  - Pessimistic scenario (asset values remain at end-2008 level): funding ratios expected to decrease to 59 percent.

### DC plans, household balance sheets, and multi-fund performance in Latin America
- Transmission channels from pension plans to households:
  - Wealth effect (share of pension in household financial assets).
  - Liquidity of pension assets for workers and retirees.
  - Portfolio rebalancing effects and annuitization risk.
- Share of household financial assets in pension funds (OECD, period through 2006 examples):
  - The Netherlands 48 percent; Switzerland 34 percent; United States 28 percent; Norway 28 percent; Sweden 21 percent.
  - Several countries: between 10 and 20 percent (e.g., Hungary and Japan).
  - Rest of OECD: less than 10 percent.
- Nature of household risk by plan type:
  - DB plans: primarily credit risk (sponsor may not honor pension promise). Households mainly exposed to credit risk in United States, Portugal, Korea and Finland.
  - DC plans: primarily investment and annuitization risk. Large DC exposures in Australia, United States, Latin America, and most of Eastern Europe.
- Importance of default investment option design for DC plans:
  - DC pension assets are illiquid for contributors; volatility affects household portfolios mainly via rebalancing and at retirement via annuitization.
  - Default investment options during accumulation phase are critical to reduce impact of pension asset volatility.
- Latin America multi-fund real returns (percent, real) Sep. 07–Sep. 08 and related periods (selected figures):
  - Mexico system Sep. 07–Sep. 08: -5.6 percent; Sep. 08: -2.4 percent.
  - Chile system Sep. 07–Sep. 08: -16.4 percent; Sep. 08: -7.2 percent.
  - Peru system Sep. 07–Sep. 08: -17.5 percent; Sep. 08: -4.0 percent.
  - Notable: participants close to retirement appear largely shielded in Chile and Mexico but not in Peru; Fund E in Chile annual real performance 0.5 percent; SB1 in Mexico minus 0.5 percent; Fund 1 in Peru minus 7.3 percent (conservative fund in Peru had unexpectedly high variable income exposure).
- Magnitude of DC losses and heterogeneity:
  - In mandatory DC systems, losses amount to 30–50 percent in aggressive funds and 0–5 percent in conservative funds (exceptions where conservative funds had large equity components: Hungary, Peru, Estonia, Lithuania).

### Pension expenses and private pension losses
- Estimates and impacts:
  - Estimates as of October 2008 for pension expenses among constituents of the S&P500 averaged US$35 billion for 2009 after a 20 percent fall in the index.
  - S&P500 subsequently fell another 35 percent implying significantly higher expensing will be necessary.
- Aggregate private pension losses and accounting effects:
  - Private pensions in OECD countries reported US$4 trillion in losses in asset values in the first 10 months of 2008.
  - Including other private pension assets in voluntary personal plans in the United States (such as IRAs) and in other countries, the loss increases to about US$5 trillion.
  - Aggregate accounting surpluses for corporate plans in S&P500, STOXX50 and FTSE350 decreased from US$246 billion on September 20, 2007 to minus US$860 billion on March 2, 2009.
  - Relative change in aggregate funding ratios: from 110 percent to 67 percent.

### Fiscal implications, guarantees, and contingent liabilities
- Minimum pension guarantees:
  - Almost all countries have a minimum pension guarantee.
  - Minimum pension guarantees vary across countries and are on average 30 percent of average earnings.
  - Example: Mexico allows workers at the time of the 1997 reform to elect a pension under the old PAYG system if the new DC pension is lower.
- Insurance schemes and guarantee fund exposures:
  - Some countries offer insurance against loss of DB plan assets due to employer insolvency (U.S., U.K., Sweden, Germany offering relatively high amounts).
  - Potential government costs from guarantee fund deficits and contingent liabilities:
    - United States: estimated potential costs amount to 0.4 percent of GDP.
    - United Kingdom: estimated potential costs amount to 0.1 percent of GDP.
- Implicit pension debt (IPD) as an indicator:
  - IPD represents a rough indicator of accrued pension system liabilities; sensitive to discount factor; ranges typically provided.
  - Table 8 reports IPD estimates for 35 low and middle income countries (source: Holzmann, Palacios Zviniene (2004)).

### Trading patterns, herding, and market stability
- Herding behavior (example: Chile):
  - Contemporaneous herding: funds buy/sell similar assets at same time (evidence for domestic corporate bonds and quotas of domestic and foreign mutual funds; other assets show herding among largest funds).
  - Dynamic herding: asset classes bought at one time are also bought in subsequent periods (evidence for domestic equities and foreign mutual funds).
  - Economic magnitude of herding close to mutual funds in developed countries but higher in some asset classes.
- Momentum strategies and effects:
  - Chilean plans: buy government bonds, former pension system bonds and quotas of foreign mutual funds when lagged returns are positive; buy domestic equity when lagged returns are negative (contrarian for domestic equity).
  - Momentum and herding can amplify price volatility when assets under management are large.

### Insurance sector implications and channels to the real economy
- Linkages with banks and financial sector:
  - Insurers' primary exposure to banks is via market securities in their investment portfolios.
  - Cross-sector risks: group-level exposures, common management failings, and pressure to seek intra-group support.
  - Counterparty exposures via derivatives and hedging programs (examples include monolines and AIG-related issues).
- Insurance-Linked Securities (ILS):
  - Outstanding ILS at end-2007: $39 billion, around half life insurance risks.
  - ILS transmit catastrophic insurance losses directly to investors without cushion of insurer balance sheets.
- Real economy impacts of insurance failures:
  - Non-life failures can reduce risk management capacity (example: HIH failure in Australia 2000–2001 affecting construction activity).
  - Life company problems can:
    - Reduce policyholder protection relative to mutual funds/unit-linked policyholders.
    - Cause immediate reductions in annuitant income.
    - Reduce confidence, potentially causing substitution to other savings markets.
- Policyholder protection and resolution:
  - Many countries have policyholder protection arrangements similar to deposit insurance; coverage and scope vary.
  - Insurance company resolution procedures are often underdeveloped or untested; regulators generally seek continuity of contracts and to avoid liquidation.
- Fiscal and government support:
  - Direct government support for insurers has been limited historically but has occurred (e.g., Australia after HIH; U.S. AIG support).
  - Insurance firms with federal regulation in the U.S. may be eligible for programs such as TARP.

### Policy conclusions and recommendations (from the source)
Findings:
- Recent turmoil generated large losses in insurance and pension industries.
- Large unfunded liabilities created in DB plans; recognition will occur over next few years in jurisdictions using smoothing techniques.
- Private pensions in OECD countries reported US$4 trillion in asset value losses in first 10 months of 2008; including IRAs and other voluntary private pension assets increases loss to about US$5 trillion.
- Aggregate accounting surpluses in corporate plans across S&P500, STOXX50, FTSE350 fell from US$246 billion on 09/20/07 to minus US$860 billion on 03/02/09; funding ratios from 110 percent to 67 percent.
- Mark-to-market losses in DC plans significant in aggressive funds (30–50 percent) and small in conservative funds (0–5 percent), with notable exceptions.

Policy recommendations and areas for IMF involvement:
- Address heterogeneous valuation, funding, accounting and disclosure standards of pension plans and insurance companies.
- Tackle procyclicality and design countercyclical policy responses.
- Help countries monitor contagion channels to the real economy and the rest of the financial sector, including the fiscal channel.
- Strengthen group-wise supervision, especially for insurance companies.
- For DB plans:
  - Recognize that minimum funding target rules and market-based valuation methods amplify contagion by imposing procyclical targets.
  - Use countercyclical policy responses to relax regulatory requirements temporarily without endangering long-term viability.
- For DC plans:
  - Mitigate two main transmission channels to the real sector:
    - Wealth effect: balance disclosure frequency and asset valuation against potential household rebalancing and consumption effects.
    - Annuitization risk: consider policies to reduce annuitization risk, including:
      - Re-evaluating design of default investment options.
      - Introducing regulatory requirements for investing cash balances in long term bonds and/or deferred annuities towards retirement.
      - Revisiting the role of life-time minimum rate of return guarantees.
- For fiscal risks:
  - Monitor heterogeneous systems of government guarantees, safety nets and eligibility rules.
  - Track potential costs from guarantee fund deficits and contingent liabilities (examples: 0.4 percent of GDP for United States; 0.1 percent of GDP for United Kingdom).

*Source: IMF staff working paper _wp09151 (2009), figures and tables as provided in the source content.*

### 0.1 percent of GDP in the United Kingdom. Regarding insurance the same applies and the

### _wp09151 - 0.1 percent of GDP in the United Kingdom. Regarding insurance the same applies and the

### Fiscal impact and crisis costs
- Fiscal impact examples cited: "0.1 percent of GDP in the United Kingdom."
- Fiscal costs from crises depend on how the crisis is managed and "are likely to increase if the economic conditions deteriorate further."

### Risk transfers to insurance and regulatory capacity
- Credit risk transfers from banks to insurers (specifically the monolines and AIG) "far exceeded the capacity of the insurance regulatory framework to capture the risks."
- Insurance regulation should continue to "address risks in the insurance business model" but also "cater for concentrations of banking-type risks, through both appropriate rules and effective supervision."
- Unsupervised risk transfers from other regulated sectors highlighted the need to strengthen group supervision.

### Group supervision and oversight gaps
- Insurance regulation remains influenced by the traditional focus on the solo company.
- Recent events showed solo insurance entities could be relatively strong (example: AIG solo entities), yet significant losses occurred on securities lending within regulated insurance entities.
- Regulators have not always sufficiently focused on risks to insurance companies from activities elsewhere in the group (holding company, banking and unregulated parts).
- Recommendation: "Insurance regulators should at least assess group risks and undertake full consolidated supervision where taking the group lead supervisor role."

### International solvency standards and measurement consistency
- Only in Europe, with the Solvency II directive, "is there a prospect of international standards akin to Basel II in the foreseeable future."
- Absence of a standard means "no common language for measuring, analyzing and comparing insurer financial strength—other than ratings."
- The crisis increased appreciation for "the additional transparency which such a standard might bring."
- Need to consider potentially procyclical elements of insurance financial regulation, for example:
  - "stress-based or claims-based solvency and reserving requirements;"
  - "unnecessary incentives for cross-sectoral regulatory arbitrage."

### Resolution, crisis management, and access to public support
- Need to revisit the resolution and crisis management framework for insurance, including:
  - Reviewing powers to intervene;
  - Reviewing circumstances in which access to central banks or government bailout could be made available.
- Regulators should be clear on the impact of failures.
- Crisis readiness should be viewed within the IAIS requirements (and so FSAPs) as "one of the preconditions to effective supervision."

### Supervising large insurance groups and macroprudential inclusion
- Consider supervising large insurance groups more similarly to major banking groups using similar tools:
  - "colleges of regulators to focus international information-sharing and coordination of regulation;"
  - effective consolidated supervision;
  - global reporting and stress testing.
- Include major insurance groups in any new macroprudential framework. Possible measures:
  - aligning insurance company reporting requirements and supervision with the need for authorities to monitor overall financial conditions in the economy, including trends in leverage;
  - more sharing of information and analysis with central banks, including of insurers in system wide stress testing;
  - increased focus on regulatory arbitrage involving insurers.

### FAS 87 (United States) — accounting for DB pension plans (Annex II)
- FAS 87 introduced in "1986" standardized actuarial assumptions for valuing pension liabilities and reporting pension assets and liabilities on the sponsor's balance sheet.
- Balance sheet treatment: FAS 87 directs reporting only the net difference between pension assets and liabilities rather than gross assets and gross liabilities.
- Income statement treatment:
  - Surplus income (loss) from the DB plan can be accounted for as operating income (loss) for the sponsor in excess of what is needed to match the increase in plan liabilities and can be credited as an intangible asset called "prepaid benefit expenses."
  - The pension expense measure "net periodic pension cost" (NPPC) is calculated as the annual accrued costs of the pension plan minus the "expected return on the plan assets."
  - Expected return is calculated as the product of:
    - (1) the assumed long-run rate of return on the plan assets (assumed by the actuary and typically different from the rate used to discount liabilities);
    - (2) the "market related value" (MRV) which can be either (2a) the fair market value of assets or (2b) a "5-year moving average" of the true market value.
  - Because the assumed return is not risk adjusted, FAS 87 "guides the actuary to ignore the risk profile of the underlying portfolio when assuming the expected return on assets."
  - Consequence: "the actual return on pension plan assets does not show through the sponsor’s financial statement."
- Empirical/accounting notes:
  - "The average plan in the United States uses 9 percent as expected return on assets and uses 7 percent to discount liabilities."
  - The accounting treatment "is considered the principal cause of the equity bias (60 percent on average) of U.S. DB pension plans."

*Source: IMF working paper content (excerpt).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2009/_wp09151.pdf_