Academic journal article Journal of Risk and Insurance

Empirical Risk Analysis of Pension Insurance: The Case of Germany

Academic journal article Journal of Risk and Insurance

Empirical Risk Analysis of Pension Insurance: The Case of Germany

Article excerpt

ABSTRACT

The book reserve system is the most widespread method of financing occupational pension plans in Germany. The pension liabilities are mutually insured by the Pensions-Sicherungs-Verein VVaG (PSVaG) against bankruptcy. The PSVaG recently stated that the insurance system needed to be reformed. In the future, risk-adjusted premiums as foreseen for the newly established Pension Protection Fund in the United Kingdom could become feasible. We perform a credit portfolio analysis to determine the risk profile of the PSVaG. The magnitude of a tail risk event suggests that under the current financing system it can only be smoothed out over decades. Under an expected loss pricing plan insurance premiums would vary greatly. In a marginal risk contribution approach the variation of the premiums would be less pronounced.

INTRODUCTION

Occupational pension plans vary widely in design and importance across countries. However, specific institutions to insure defined benefit pension plans against bankruptcy of the sponsoring company exist only in a few countries. Sweden and Finland were the first to establish pension insurance systems in the early 1960s, followed by the United States and Germany in 1974 and Japan in 1989. In the United Kingdom, the first such insurance system was introduced in 1995 as a consequence of the Maxwell scandal, in which 30,000 employees lost their pensions when the pension fund assets were pledged as collateral. As a result of the severe underfunding of many pension plans and several large bankruptcies, the U.K. government established the Pension Protection Fund (PPF), which became operational in April 2005.

The United Kingdom's PPF is consequently based on risk-adjusted premiums according to the insured firms' default probabilities and funding status. By contrast, the Pension Benefit Guarantee Corporation (PBCG) in the United States charges a flat premium per insurant, to which a supplemental variable premium for underfunding was only added in 1987. In 2006, the insurance premium per participant was increased from $19 to $30 to cover the severe underfunding of the insurance plan. In Germany, the premiums of the Pensions-Sicherungs-Verein VVaG (PSVaG) are based on the annual costs of the pension insurance plan and are not risk-adjusted.

The financial literature is almost exclusively focused on the PBGC. Since its inception, several authors have pointed out the moral hazard problems created by nonrisk-sensitive premiums and the pricing problem that can be linked to a conditional put option (Niehaus, 1990; Sharpe, 1976; Treynor, 1977). Several articles apply the option pricing framework developed by Black and Scholes (1973) and Merton (1973) to approximate the cost of insurance under numerous simplifications. They provide illustrative solutions for hypothetical pension plans (Bodie and Merton, 1993; Pennacchi and Lewis, 1994; Seow, 1995) or apply their models to a sample of insured plan sponsors (Marcus, 1987; Hsieh, Chen, and Ferris, 1994; Lewis and Pennacchi, 1999). VanDerhei (1990) uses a large sample of plans and sets premiums directly equal to the product of the risk of an insufficient termination times the amount of exposure. Many of the risks involved are exemplified by the savings and loan crisis of the late 1980s (Bodie and Merton, 1993; Bodie, 1996).

In Germany, the PSVaG has almost completely been ignored in financial research. The only empirical study has been carried out by Grunbichler (1990), who exemplarily calculated risk-adjusted insurance premiums for a sample of 22 large listed corporations using a Merton-type approach (Merton, 1973, 1977).

Attempts to measure the overall long-term risk of the PBGC were made by Estrella and Hirtle (1988) and Lewis and Cooperstein (1993). The full conceptual complexity of the pension insurance system is addressed within an integrated framework by Boyce and Ippolito (2002), who use the stochastic Pension Insurance Modeling System (PIMS) introduced by the PBGC in 1998 to analyze the risk profile as well as a variety of pricing plans. …

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