In ancient Greek mythology, the monster Proteus was a formidable adversary because in a battle he could take the form of any living creature he wanted. Life and pension liabilities can take on a similarly protean quality at times.
Take the battle over market-consistent valuation. In many respects, this is a battle that has been won: the market value of liabilities is a de facto benchmark, and providers have seen enough cautionary tales such that they no longer wait for regulators to tell them to improve their solvency. The shareholder-driven move by Munich Re last year to hedge interest rate convexity risk is an example of this.
But like Proteus, no sooner has one risk apparently been brought under control than does another more shadowy one rear its head. Consider the recent debates about longevity in UK pensions accounting.
As discussed at the recent Life & Pensions summit, FRS17 permits the sponsors of defined benefit schemes to use undisclosed, potentially out of date mortality assumptions in calculating pension liabilities. Once calculated, the liability is then discounted at market rates.
But applying market rates to an unrealistically small liability is the same as using below-market rates to discount a realistic liability. And which finance director would not pass up the chance to finance at below the market rate? Particularly when the UK's Pension Regulator seems to encourage this practice.
Of course, the risk hasn't gone away, it has just been buried in a hidden longevity risk reserve which has a potential claim on future corporate cash flows. New insurance start-ups seeking to take on corporate pension liabilities have to ask their shareholders for this risk capital up front, thanks to a very different regulator, the Financial Services Authority.
Now there is no fundamental reason why pension scheme sponsors can't be more open with their shareholders about longevity risk. After all, the chief actuary of Denmark's supplementary state pension scheme, ATP, told the Life & Pensions summit that he updates ATP's longevity reserve every day. The new UK buyout companies seem to be betting on this happening sooner rather than later.
For another example of Proteus at work, look at German life companies. The smarter players, such as Munich Re, realised that the archetypical with-profits savings product with a minimum interest guarantee poses a threat to shareholders. They sought protection from falling rates (niedrigzinsabsichern) in the swaption market, which allows them to continue selling such products in the future.
But what about the threat of rising interest rates? Once swap rates exceed bonus participation rates by a certain level, there is a danger that policyholders will seek better returns elsewhere and will either allow policies to lapse or surrender them. However, there are plausible arguments that this threat is over-estimated because life savings policies are typically one-off transactions and are not subject to an ongoing rational financial analysis by customers despite a regular premium being paid.
As German actuaries and heads of ALM will freely admit, no-one has a clue what the right answer should be, because experience of sharply rising rates is only a distant memory for most practitioners. So companies will calculate their own lapse risk reserves. Some will reduce this capital by hedging, but most will not.
For all the laudable efforts to manage financial risk in the derivatives markets, the spirit of Proteus is here to stay.