**Flexible Regulation.** A tight regulation along the preceding lines would introduce considerable rigidity in the management of traditional and escalating participating VPAs. Such rigid regulation is not generally recommended since it may well cause competitive distortions and impede product innovation. It is only envisaged as a temporary solution for countries with underdeveloped insurance and financial markets. A more flexible alternative is to allow annuity providers to determine their initial benefit payments and their own profit distribution policies and smoothing mechanisms but to require a high level of meaningful transparency.

This is the approach that is followed in Denmark (see Box 3), although it does not appear to address fully the need for meaningful transparency. In addition to requiring formal notification of profit-sharing policies, the Danish FSA compiles an annual table with data on the impact on policyholder returns of the equity risk premium awarded by each provider to its equity capital. This is a step in the right direction for countries where integrity risk is under effective control, although more needs to be done to ensure adequate transparency and comparability. In particular, the table should also include data on the level of operating costs of different providers and the returns obtained by policyholders.

Many other OECD countries, including Australia, Canada, the Netherlands, Sweden, the United Kingdom and the United States, also do not impose minimum profit participation rates. In the United Kingdom, the FSA imposes a general duty on providers to treat customers fairly and also requires providers to publish their Principles and Practices of Financial Management (PPFM). But the FSA does not compile any data on the extent to which providers comply with these requirements or on the relative performance of different providers. There is also no indication of the practical usefulness of PPFMs. The PPFM of the British Prudential is posted on its website, runs for no less than 48 pages, and is completely incomprehensible. This is an example of futile transparency.

# **4.2 The Regulation of Reserving Policies of Traditional and Escalating Participating Annuities**

Maintaining adequate reserves is essential for ensuring the ability of annuity providers to meet their obligations toward pensioners. However, reserving policies are complicated by the offer of guaranteed minimum benefits and the use of complex smoothing mechanisms.

Providers of variable payout annuities are required to maintain separate reserve accounts for their VPA business (participating or unit-linked) and their fixed annuities. Traditionally, the accounts of providers were based on book values or amortized cost but increasingly accounting standards require the use of fair value accounting which implies the use of market values for actively traded assets and model valuations for illiquid and infrequently traded assets.

To determine the required level of reserves, best estimates of future benefits are first projected by assuming that the future realized investment rate of return (RIR) is equal to the AIR and are also adjusted for changes in longevity. The longevity adjustment is based on gender-specific mortality projections (even if unisex tables are used for pricing and benefit-setting purposes) and may take place on a periodic basis when it becomes apparent that observed mortality is significantly different (usually smaller) from what has already been assumed and built into the reserves. Future benefits are then discounted to the present at the AIR. This implies that if there 19