Solvency threat facing pension fund & insurers

“Central to this forecast is my expectation that household de-leveraging, which is now underway on both sides of the Atlantic, has much further to run. In other words, we are in a balance sheet recession. When that happens, debt reduction becomes the priority. Savings rise and consumption falls at the expense of economic growth.” Niels Jensen (Absolute Return Letter)

Still bullish on bonds

Solvency II will govern capital adequacy standards in the European insurance and life insurance industry. It represents a complete overhaul of the existing rules (Solvency I), which date back to the 1970s. One of the pillars of the new directive is the introduction of a risk-based approach to reserving. Going forward, European insurers will have to be able to pass a 1-in-200 years’ event stress test, which has been designed to give the industry enough cushion to withstand even the most severe of bear markets without being forced to sell out in the darkest hour. Risky asset classes such as equities, commodities and other alternative investments will be assigned much higher reserve requirements than less risky asset classes such as bonds

Niels Jenson continues to be bullish on bonds – (http://www.fxstreet.com/fundamental/analysis-reports/outside-the-box2/2010-10-
05.html)

Going forward, the main issue facing the (pension fund) industry (and that is the same for insurers and pension funds) is the relentless drop in bond yields. As yields come down, so does the discount rate which is used to calculate future liabilities. A lower discount rate in turn leads to a falling solvency ratio. In the first half of this year alone, solvency fell by 13% on average as a result of falling bond yields .“

If you can see your pension fund sinking like the Titanic, but you know you have a good shot at saving the ship, if only you fill up the portfolio with high yielding government bonds, it must be very tempting to stuff your portfolio with Greek (10-year currently yielding 10.7%), Irish (6.6%), Portuguese (6.4%) and Spanish (4.1%) government bonds. It is one heck of a gamble but, then again, desperate people do desperate things.

Remember what I said earlier this year about inflation being difficult to engineer when you need it the most? Unfortunately, this is truer than ever. We could really do with a bit of inflation and the higher bond yields which would probably follow (it would fix an awful lot of problems in the pension industry), but it is when you need it the most that it is least likely to happen.