Banking the risk premium

Suppose yourself to be an expert gambler with an average return on your stake of 10%. With your winnings reinvested every year, you calculate that when you retire thirty years from now, you will expect to have made a million pounds. Should someone promise you a £1 million pension in return for your expected winnings?

Caricatures aside, this parable says something about how the pensions and insurance world operated until recently. It was a world that took credit for the risk premium, banking its compounded value as an asset today, and pledging that value as collateral against long-term liabilities that resemble loans. But this view ran up against the repo man of the markets: the collateral of expected returns is now seen as a false promise.

According to the new market-consistent thinking, there is only one truly objective way of compounding the growth of assets over time: the risk neutral way. A risk neutral expectation ignores investor preference for risk, and all assets have the same compounding rate: the risk-free return on government bonds or collateralised deposits.

To the traditionalists, the old habit of banking the risk premium dies hard. For pensions practitioners, switching to the market-consistent approach seems to destroy cash (which of course was never really there in the first place), and it exposes deficits which then have to be funded. When those who built their defined benefit (DB) schemes on such foundations of sand react by closing the DB scheme, it is all too easy to blame the change in valuation that brought the problems to light.

For insurance practitioners, the change is more subtle, but can be seen in the way that companies report embedded value. Moving from a 'real world' valuation of in-force policies that takes credit for the risk premium to a market-consistent valuation that accounts for the time value of options and guarantees, makes guarantee-intensive businesses less attractive. The natural response is to move into different businesses where customers take all the risks or pay explicitly for hedging them.

The broad response to market consistency in both worlds has been similar: a shifting of risk onto individuals. The danger with such a shift is that individuals might also bank the risk premium, projecting a compounded return to retirement which might convince them to save less than they need.

The financial services industry does not have a good track record in advising individual customers about such pitfalls, despite the high fees and commissions that until recently have been charged for 'advice'. Being individuals, customers who get burned by the risk premium are likely to seek compensation for their pains, or at the very least, go to the government for help.

Lord Turner, head of the UK's Pensions Commission, has made no secret of his dislike for the advice-driven model, and seeks to eliminate it with his low cost National Pensions Saving Scheme. But even Turner appears to have succumbed to the sophistry of the risk premium, which he depends upon to make his proposals work.

And a paper dart's throw away from Turner's office in the Department for Work and Pensions, consternation broke out last year when the UK's Actuarial Profession proposed allowing individual members of DB pension schemes to transfer out using the market-consistent value.

But if an individual wants to transfer out of a scheme in deficit, what does market consistent mean? UK regulators already track two parallel measures: the going concern basis such as FRS17, and the cost of buy out. Here a new risk premium enters the picture: the return that shareholders of an insurance company expect when they buy out a block of pension liabilities.

Now the right to make such key recommendations is being taken away from the Actuarial Profession and being handed to the newly formed Board for Actuarial Standards (BAS). So far, BAS has intimated that it will enforce a principle of consistency, similar to the view expressed by its neighbour, the Accounting Standards Board in its drive to improve pensions accounting.

But for all the drive towards market consistency, the risk premium is very hard to remove from insurance and pensions valuation.