Investments

In Investments the Focus Was on Minimising Losses

 

Considering the circumstances, Suomi Mutual’s market-based annual return on investments in the last operating period was reasonable. The annual return was -4.0 per cent. Without the change in the value of the swap basket hedging technical provisions the return would have been -8.7 per cent.

Year of the black swans

2008 will probably go down in history as the year that marked the end of the borrowing-oriented neoliberal economic policy, at least in its present form. Market mechanisms proved vulnerable and inadequate as economic guiding instruments. There is an urgent need for corrective measures and the government is expected to take a leading role in implementing them. There are calls for more regulation, and Keynesian economic thinking is rapidly gaining support.

 

The investment environment was influenced by extreme phenomena known as black swans, which have a negligible historical probability of occurring. The crisis, which started on the US housing market, became global and in the end paralysed the entire banking sector. When the crisis came to a head in autumn, lack of liquidity made the markets extremely volatile and risk premiums reached record levels.

 

 

 

Valuations of equities and other risk investments were no longer determining the course of the markets. Whatever the offer price for shares, buyers were not attracted to them. The markets ceased to function. Especially towards the end of the year, markets were characterised by sheer panic and a struggle for survival. Traditional investment models were no longer applicable and hedge funds ran into trouble. The downward spiral accelerated. Towards the end of the year, real estate and private equity investment markets also collapsed. It was interesting that the traditional approach of diversifying risks in different asset classes was no longer valid. Almost all risk taking was punished. For a while, it seemed that investments on credit-risk-free money markets would become best-sellers. However, at the end of the year, as a result of the strong stimuli administered by different governments, long-term interest rates, too, bottomed out. Thus, at least the taking of interest rate risk was rewarded.

 

 

 

The investment environment of 2008 was also characterised by lack of transparency. At the start of the year, it was still unclear which of the problems of the world economy were specious and which were real. Should governments focus on combating inflation or on supporting growth? Are China and other emerging Asian economies strong enough to assume the role of the engine of growth, up until now played by the USA, and prevent the crisis from becoming global? What are subprime loans and how large are the problems they are causing banks? What other types of problem loans are there in the banks’ balance sheets and how numerous are they? Corporate executives were not even able to make short-term predictions about their business. Strong order backlogs created an illusion of continuous demand. The sudden end to economic growth came as a shock to many and no preparatory measures had been taken.

 

However, as the year progressed, it became increasingly clear that in the global economy there is one dominant problem: As a result of the financial crisis, the world economy was entering the worst downturn since the 1930s. It could only be prevented if the boosting of economic growth was made the number one economic and monetary policy target. Compared with the early part of the year, the number of problems had decreased. It was encouraging to see how strongly and forcefully world governments acted and, almost unprecedently, took cooperative measures to coordinate their action at a time of common peril. Now, at the start of 2009 as this review is being written, it seems that the massive measures taken have helped. It seems that the worst of the banking crisis itself is already over. In the equity markets, too, the expectation seems to be that 2009 will be much better than 2008. As for the real economy however, the year has got off to an exceptionally bad start. Therefore, the danger is that as the downturn drags on, the markets will again be disappointed.

Efforts to minimise losses reasonably successful

The return on Suomi Mutual’s investment operations in 2008 was -4.0 per cent (5.6 per cent), which in the prevailing circumstances was a reasonable achievement. In Euro terms, the 2008 investment returns totalled EUR -267 million (EUR 366 million). The result includes the positive result of EUR 330 million from the swap basket taken at the start of the year for the purpose of hedging technical provisions. Without it, the return on investment operations would have been EUR -598 million, or -8,7 per cent.

 

 

The result fell substantially short of the targeted 2008 return of about EUR 200 million, which was derived from the requirements set for the return on technical provisions, competitive customer bonuses and the market-based return on equity.

 

Because of the loss, the company did not distribute significant special additional benefits or customer bonuses for 2008. The company’s solvency nevertheless remained strong at the end of the year and its capacity to bear investment risks was good.

 

Considering the general market trends, Suomi Mutual’s investment performance was reasonable. The company was particularly successful in its efforts to manage equity risk. As a result of successful hedging, the loss on equity and private equity investments was only 27.8 per cent, compared with 43.2 per cent recorded by the benchmark index used by the company. No pre-emptive value adjustments were directed at private equity investments. Fixed-income investments (excluding the swap basket hedging technical provisions) were adversely affected by the substantial rise in credit risk premiums and the high allocation to credit-risk bonds. Fixed-income investments yielded an overall annual return of -0.2 per cent, compared with the return of 8.2 per cent generated by the benchmark index consisting of risk-free government loans and money market investments. The proportion of equities in the investment assets fell during the year from about 28 per cent to around 20 per cent. About a half of this total was hedged using derivatives at the year’s end. The corresponding proportion of fixed-income investments rose from approximately 57 per cent to 63 per cent.

 

 

In real estate investments, the company fell short of its targeted return of 7.0 per cent. At the end of the year, the downturn also hit real estate funds and pushed the total return on real estate investments to 4.6 per cent. At this stage, the problems in the investment environment did not have any impact on the direct real estate portfolio. At year end, the real estate portfolio was more or less evenly divided between indirect funds and direct holdings. At the end of the year, real estate investments accounted for about 11 per cent of the investment assets.

 

About 4.5 per cent was invested in hedge funds at the end of the year. These funds yielded a return of -15.3 per cent or EUR -57 million during the year. The result was unsatisfactory, but substantially above the benchmark index. Commodity investments accounted for about 1 per cent of the investment assets at the end of the year.

 

 

Challenging principles for business operations

A few years ago, Suomi Mutual’s Board of Directors approved new principles guiding the company’s business operations. According to these, the company’s net assets will be distributed to policyholders as special additional benefits. The main principle is that assets will be distributed when a decrease in the company’s technical provisions or an increase in investment returns generate capital that is not needed to cover the risks related to an investment portfolio yielding competitive returns.

 

In line with the principles guiding its business operations, Suomi Mutual’s annual investment-return target is market-based. The targeted return for technical provisions is sought from the fixed-income markets and the targeted return for the solvency capital to be retained in the company from equity markets. When the company is pursuing the target, it must never allow the investment risk to exceed its risk-bearing capacity.

 

New decisions, measures, plans, targets and circumstances always mean new investment challenges. The structure of the investment portfolio and operational targets and procedures must be adapted to changing circumstances. Last year operations were characterized by adjustments to an increasingly volatile investment environment.

Revolution in investment operations

For many years, the main objectives and tasks in Suomi Mutual’s investment operations remained unchanged despite changes in the structure of the investment portfolio and the balance sheet. The company’s investment operations were managed with the long term in mind, securely and productively, but to a great extent on its own terms. Return meant the return on the investment assets and risk mainly meant the fluctuation in the value of the investment portfolios. In practice, the aim was to generate investment returns and use capital with maximum efficiency as the company’s solvency was strong; in other words its capacity to bear investment risks was high. In reality, already at that time the company’s technical provisions contained a significant interest risk, and the impact of this on the company’s solvency was overlooked.

 

As of the beginning of 2008, Suomi Mutual started in its internal accounting to value technical provisions in accordance with the fair-value principle. This was in keeping with new and planned official regulations (the new Insurance Companies Act and Solvency II). The change was highly significant and it had a substantial impact on the control of and targets for investment operations. Fixed-income investments in particular, became important as instruments for hedging interest rate risks contained in the technical provisions and were no longer merely vehicles for seeking returns. At the same time, the change in the value of the technical provisions became a component that has a direct bearing on the company’s internal result. The interest rate risk must therefore be managed as a single entity in which the active interest rate risk is determined as the net risk between the investment risk and the risk of a change in the value of the technical provisions and the derivatives basket hedging it. Likewise, both the traditional investment return and the change in the value of the unhedged technical provisions must be considered when returns are sought.

Operations guided by the plans

The investment operations of Suomi Mutual are guided by an investment plan approved by the Board of Directors. The method for measuring and calculating the risk-bearing capacity and investment risks is determined in the risk-management plan. The investment plan lays down the return and liquidity targets for investments, which are derived from the nature and structure of technical provisions. To secure adequate diversification, the plan lays down the maximum and minimum amounts for each asset class. It also sets out the principles guiding foreign currency investments. The investment organisation and its powers are also described.

 

Suomi Mutual’s Board of Directors and the company’s own experts are responsible for investment planning, strategic steering and the selection and supervision of cooperation partners. Pohjola Asset Management Ltd provides the accounting and reporting services required by Suomi Mutual in its investment operations. Pohjola Property Management Ltd, either on its own or together with its subcontractors, is responsible for the operational functions connected with the maintenance and administration of Suomi Mutual’s real estate holdings.

 

Some of Suomi Mutual’s equity investments are directly managed by the company itself. Suomi Mutual has outsourced some of its fixed-income investments and a substantial proportion of its equity-fund investments to companies outside the OP-Pohjola Group. The aim (of the company) is to find the asset manager with the optimal knowledge for each mandate.

 

Major Mutual Fund Investments		Market value Dec 31, 2008 EUR million
1.	OP-Corporate Bond Prima Fund	218
2.	R2 Crystal Fund - Euro Class 1	138
3.	OP-Cash Manager Fund	92
4.	UBS (Lux) Institutional Sicav - US Equity Growth	89
5.	Aviva Global Convertible Bond Fund	80
6.	T. Rowe Price-Global High Yield Bond Fund Class I	73
7.	Nordea Pro Euro Money Market Fund	66
8.	OP-Corporate Bond Fund	62
9.	OP-High Yield Fund	61
10.	OP-Euro II Fund	57
11.	Nordea Euro Money Market Fund	53
12.	Fidelity Emerging markets Fund	48
13.	Evli Alpha Bond IB	47
14.	Parvest US Small Cap Inst	46
15.	Invesco Japanese Equity Core Fund C JPY	45
16.	Nordea Pro Corporate Bond Fund/100	39
17.	Natixis Loomis Sayles Senior Loan Class S	38
18.	Financial Select Sector SPDR	38
19.	R2 Alpha Strategies I fund – Euro Class I	36
20.	Pimco Global Investm Grade Credit Fund, Inst Inc	35