Playing regulatory poker

The relationship between life and pensions providers and governments is evolving. For the providers, risk management is now at the core of supervision, and regulators increasingly regard encouraging good risk management to be a core responsibility. For years, supervision has been about rulebooks, but despite companies employing armies of box-ticking staff and expensive lawyers, regulators have been rightly concerned that risk management and business decisions are taken separately.

The development of Pillar II supervision is an attempt to rectify this. Rather than tick boxes, companies must assess their own balance sheets and risks and make a case to regulators. Instead of a formal exercise in paperwork, the relationship between regulator and regulated is akin to a conversation, and senior management are expected to be involved.

Such changes have their own challenges. As risk management becomes increasingly sophisticated, some might wonder if regulators are truly capable of managing the dialogue fairly. Might they not depend upon a secret rulebook or model (perhaps written by consultants) that informs their conversations with companies?

There are also concerns about game playing. Regulators give messages, sometimes vague and apparently contradictory, about what they want to see in a Pillar II process. Some companies that have been burned in the past might respond with excessive caution, but others might look for ways of finessing their self-assessment or internal modelling skills to reduce their capital.

After all, if (as regulators want) board members and senior business people really get involved with risk management, they will apply the rules of business to it. And these rules say nothing about not exploiting an unfair advantage.

For a different kind of unfair advantage, look at the corporate sponsors of UK occupational pensions schemes, many of which enjoyed illusory surpluses based on non-market consistent accounting until they had built up enormous deficits. Risk-based regulation can go only so far in such cases, as the Pension Protection Fund recently acknowledged.

But the relationship between supervisor and supervised is not just about protecting policyholders and scheme members. The governments to whom supervisors are ultimately accountable are facing risk management problems of their own, with a difficult balance required between social and financial sustainability of their pensions systems amid the challenge of increasing longevity.

Here the life and pensions providers are expected to deliver solutions that lower the burdens on taxpayers. Answerable to these taxpayers, governments want the solutions delivered at low cost. But the business models of many providers often depend on a distribution structure that maximises the total expenses customers pay for investment products.

The cleverer providers have realised this, and are seeking to design long-term products that discourage 'churning' by distributors or advisers. But there is plenty of capital in the system available to fund short-term strategies that undercut such innovations. An impasse of this type appears to have been reached in the UK regarding the role of insurers in state pension provision.

We have to be grateful to Lord Turner for exposing the futility of such self-defeating behaviour, and await with interest to see what the insurance industry plans to do about it. Because if the industry cannot find a way of guaranteeing long-term returns at reasonable cost, savers will probably gravitate towards government bonds as the safest way of guaranteeing their retirement income.

Taxpayers will have to fund these bonds, which somehow defeats the purpose of state pension reform in the first place.