## Solvency II for pensions?

What is the difference between a pension and an annuity?  One simple definition is as follows:

1. An annuity is a guarantee to pay a given sum each year until death.
2. A pension is a promise to pay a given sum each year until death.

Casual readers could be forgiven for thinking that pensions and annuities have a lot in common, and that they should therefore be regulated in a similar manner.  After all, both annuity portfolios and pension schemes are exposed to a host of similar risks, such as increased longevity.

Despite this, the regulations for funding pension schemes are typically less strict than they are for insurance companies.  One example is that pension schemes are allowed to run a deficit, i.e. hold fewer assets than liabilities.  An insurance company in the same position would be closed down.  Indeed, the pending Solvency II standard will demand that EU insurers and reinsurers to be able to withstand rare, "1 in 200" events.  Pension schemes will be spared such rigour.

One proposed rule for longevity risk is that insured reserves are able to withstand a mortality shock of an unplanned immediate 20% reduction in mortality rates.  No such requirement is proposed for pension schemes.  This is an odd state of affairs, as it is getting harder to distinguish between "ordinary" businesses and insurers when it comes to longevity risk.  This is illustrated in Table 1 for four selected companies in the FTSE 100 Index:

Table 1. Longevity liabilities for four selected UK-listed companies.  Source: 2009 pension-scheme liabilities from LCP's "Accounting for pensions 2010" report, plus Form 14 liabilities for end-2009 in the PAL and PRIL annuity subsidiaries for Prudential.

CompanyLongevity
liabilities
Royal Dutch Shell
£38.8 bn
Prudential plc
£33.4 bn
BT
£33.3 bn
Royal Bank of Scotland£30.8 bn

Table 1 shows four companies with large longevity-related liabilities.  Some people might question why only one of the four companies is subject to insurance-style regulation.

Assume we have a random variable, $$X$$, with expected value ... Read more