New rules to clampdown on the pensions industry's dealings with hedge funds are being introduced in Denmark.

The Financial Supervisory Authority in Copenhagen will require pension funds to submit quarterly reports on their alternative investments to track their use of hedge funds and exposure to private equity and infrastructure projects.

The decision follows funds' failures to account adequately for risks in their investment strategies, according to an FSA report.

Denmark is home to the world's top-ranked pension system and the industry is worth $500 billion, but regulators have observed a surge in risk-taking linked in part to more widespread use of hedge funds.

Pension funds in Denmark are allowed to invest according to a so-called 'prudent person' model, rather than setting outright limits.

Denmark is currently the only country in the EU to have adopted the system, having done so in 2012

FSA deputy director general for pensions, Jan Parner, says the approach has proven problematic and has warned the rest of the EU, which is due to adopt the system from 2016, of the potential pitfalls.

"The problem is that it's not clear what a prudent investment is and the challenge for European supervisors is to explain to the industry what prudent investments are before the opposite ends up on the balance sheets," he said.

"There's a concern that funds underestimate the underlying risk and get too high a concentration in certain areas, exposing funds to credit risk, which is cyclical and which funds haven't previously had."

The prudent person principle is part of a sweeping overhaul of insurance regulation that's been more than a decade in the making.

Solvency II, as the framework is known, will give companies greater flexibility to invest while tying capital requirements to the risk they face of being unable to meet their liabilities.

"We're moving away from a prescriptive setup and more work has to be done Europe-wide in this area to be ready for the launch of Solvency II," said Parner.

First published 23.10.2014

Lindsay.sharman@wilmington.co.uk