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Introduction "During the last ten years or more there has been a pervasive global trend across all financial services sectors towards the use of more market-based, quantitative and probabilistic measures of risk, capital and value for the purposes of financial reporting and regulatory capital assessment. Major regulatory developments such as Basel II /III in the banking sector and Solvency II in the insurance sector are prime examples. The Defined Benefit Pension sector has similarly experienced a number of developments in recent years that have moved the assessment of DB pension fund liabilities and their funding in this direction, albeit to a more limited degree than has occurred in insurance and banking. A recent initiative by the European Insurance and Occupational Pension Authority (EIOPA) could pave the way for a significantly more quantitative and market-based approach to the assessment of the funding adequacy of the European Union's Defined Benefit pension funds. This initiative could provide greater consistency between the treatment of equivalent obligations that can arise in policies written by insurance companies such as fixed and deferred annuities and in the promises made to Defined Benefit pension fund members. With the bulk of DB pension funds now closed and with liability structures that are increasingly convergent with those of annuity-writing life insurers, such consistency has attractions. It may provide greater transparency on the comparable levels of security of similar assets that the public own in the form of insurance policies and accrued pension fund benefits. And for the UK actuarial profession, it may provide a means for developing their understanding of how some of the quantitative and market-based risk management expertise developed in the insurance sector over the last ten years can be applied to risk management of DB pension funds. Whilst the liabilities of closed DB pension funds increasingly resemble the simpler types of life insurance liabilities, more complex issues can arise on the asset side of a DB pension balance sheet. This is particularly the case for pension funds that are currently significantly under-funded on a mark-to-market basis, i.e. where the market value of the pension fund's asset portfolio is significantly lower than the present value of the promised liability cashflows when discounted at risk-free interest rates. In this circumstance, the pension fund sponsor's commitment to make good on any shortfall that ultimately arises in the delivery of the pension promises can be regarded as a significant asset on the 'holistic balance sheet' of the pension fund. If we assume the sponsor will make good on their commitment except when they are unable to as a result of corporate insolvency, this asset, often referred to as the sponsor covenant, can be considered as a form of corporate debt owned by the pension fund. The EIOPA proposals place the market-consistent valuation of the pension fund's assets (including the sponsor covenant) and liabilities at the centre of the quantitative assessment. Determining a market-consistent value for the sponsor covenant can be significantly more complicated than the mark-to-market valuation of the sponsor's other corporate debt. This is primarily because the amount that is owed by the sponsor at the time of default is generally unknown: pension funds will typically have significant market, interest rate and longevity risks that make the ultimate ability of the existing asset portfolio to fund the liability cashflows uncertain. Put another way, in the scenario where the corporate sponsor defaults, the shortfall (if any) suffered by the pension fund is not a pre-defined, fixed quantity. Furthermore, the economic scenarios that result in corporate default may also typically result in higher-than-average pension fund deficits. So the very times at which the sponsor covenant is most required may also be the times when it is least secure. Developing market-consistent valuation methods to rigorously account for such features will generally be significantly more complex than valuing a fixed stream of corporate debt cashflows. This paper discusses how a market-consistent valuation of the sponsor covenant can be undertaken. Section 2 provides a general overview of the valuation problem, and introduces a Monte Carlo simulation framework for the valuation of the sponsor covenant. Several case studies are provided to illustrate the valuation dynamics produced by the method. Section 3 develops simpler, faster calculations that aim to approximate the full valuation methodology set out in Section 2. Again, case studies are used to illustrate the accuracy and reliability of the approximation methods across a range of circumstances. Section 4 moves beyond the valuation problem and considers how the market-consistent pension fund balance sheet can be used to assess risk-based capital requirements. As per the EIOPA proposals, a 99.5% 1-year Value-at-Risk framework similar to Solvency II is considered. The risk management incentives generated by such a capital assessment framework are also discussed in this section. Finally, section 5 sets out the paper's conclusions."

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