Reconciling Short Term Risks and Long Term Goals
for Retirement Provisions
Name Applicant
Michel Vellekoop
Senior Researchers (Excluding new staff of PhD position and an UD Tenure Track)
Prof. Michel Vellekoop
Dr. Jiajia Cui
Dr. Berend Roorda
Prof. Hans Schumacher
Dr. Roger Laeven
Prof. Bertrand Melenberg
UvA
UT/APG
UT
UvT
UvT
UvT
40%
40%
40%
40%
40%
40%
Prof. Eduard Ponds
Prof. Anja De Waegenaere
Prof. Enrico Perotti
Prof. Alexander Michaelides
Dr. Rob van den Goorbergh
UvT/APG
UvT
UvA
LSE
APG
40%
20%
10%
10%
10%
Introduction to the Theme Proposal
The current financial crisis has severe consequences for insurance companies and pension funds.
After the worldwide fall of equity prices, central banks all over the world have responded by
lowering interest rates. This means that funding ratios have been hit by two adverse effects which
deteriorated the value of assets and liabilities at the same time. Another negative consequence of
the crisis is the higher volatility and reduced liquidity in current financial markets. This may force
institutions to liquidate parts of the asset portfolio to raise the funds for certain payments, at a
time where it is disadvantageous to do so.
It is to be expected that the financial crisis will lead to a completely new regulatory framework
which must define a careful trade-off between long term goals for investment returns and short
term constraints on the associated risks. This Netspar Research Theme will deal with the question
how such a trade-off should be made.
Our theme will consider both the position of the regulator and the position of the regulated
institutions. The regulator needs to define new risk measurement procedures and the appropriate
constraints to impose on the measured risks. The institutions may need to consider new
instruments and strategies to comply with such constraints while remaining committed to their
long-term goals in the more challenging environment after the financial crisis. We have organized
our theme in two subthemes in which these two aspects are treated.
Subtheme A : The Tension between Short and Long Term Goals: Risk, Regulation and
Solvency
Solvency Capital & Regulation
The current crisis calls for new answers to some fundamental questions on solvency capital and
regulation. The dominant economic determinants underlying the optimal amount of solvency capital
must bed studied to determine how much capital institutions should optimally hold.
What is the economic rationale for capital requirements imposed by a regulatory authority, are
they effective and efficient and how should they be combined with other regulatory tools?
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Risk Measurement
Establishing the required solvency capital is only possible if reliable measures for risk can be
defined. It is important that these measures, which ultimately determine the trade-off between
short term risks and long term goals, are chosen in such a way that they are consistent over time.
Moreover, they should be able to capture the preferences of pension providers and insurance
companies and this may take us outside the traditional class of utility functions which are favored
in the academic literature.
Which (combinations of) regulatory risk measures give rise to desired and consistent behavior of
the regulated institutions?
Subtheme B : Strategies to Resolve the Tension
Optimal Exposure to Illiquid Investments
Their long investment horizon makes pension funds and endowments natural candidates for
investing in asset classes with long-term commitments. In particular, new asset classes such as
hedge funds, private equity, direct real estate, infrastructure, energy companies or timber land and
other natural resources can be attractive for long-term investors because of the potential portfolio
diversification benefit, inflation hedging properties and inherent liquidity risk premium.
What is the optimal exposure to illiquid asset classes for long-term institutional investors? What is
the impact of the lack of liquidity of these assets on portfolio choice?
Longevity Risk Management
When valuing life insurance policies the uncertainty due to the trends in mortality rates must be
taken into account. The direct effect this will have on the solvency requirements for companies that
sell such policies, highlights the importance to assess longevity effects adequately within the
regulatory framework.
Which solvency requirements for longevity risk should be imposed from a regulatory viewpoint, and
what risk management tools might be used to hedge this risk?
Using Derivatives in Strategic Asset Allocation
Derivative structures such as swaps can be used to reduce the exposure to foreign exchange and
interest rate risk, but institutions realize that cashflows to counterparties may increase in volatile
and adverse market conditions. At the same time, derivatives can provide an opportunity to avoid
problems in times of reduced liquidity, and may allow institutions to earn premia for jump risk due
to their long time horizon.
What can various types of derivatives contribute to the long term goals of institutional investors
given their short-term constraints on risk?
Internal Markets & Contract design
Determining the optimal holding of illiquid assets and derivatives focuses on the asset side of the
portfolio, but we will also look at the possibility to introduce changes on the liability side using
contract design and internal markets. We would like to design individual policies which give holders
the opportunity to optimize for their personal situation, without sacrificing the collective sharing of
risks. Possible methods to achieve this are replacing the current uniform policies by age- or wagedependent policies, or the creation of internal markets for young and old participants, in which
aggregate wage growth rates can be exchanged for equity returns. How can we design realistic
age-dependent contracts or intergenerational markets in collective pension schemes to hedge longterm and cyclical economic uncertainties?
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