2 Risk Management

2.1 Risk management principles

2.1.1 Purpose of risk management

The purpose of Suomi Mutual’s risk management is to ensure that the risks which are under the company’s control do not jeopardise the attainment of the company’s objectives.

2.1.2 Management of Suomi Mutual operations

Suomi Mutual employs 11 people. The day-to-day management of the company’s operations has largely been outsourced. The Suomi Mutual staff is responsible for ensuring that the company’s operations, organised in this manner, meet policyholders’ requirements and that the outsourced operations fulfil the financial and qualitative targets set for them.

2.1.3 Risk identification

Suomi Mutual identifies in advance the risks threatening its operations and objectives and lists them in a separate risk management plan. The company applies methods for measuring risks and their probabilities and for preventing risks or at least reducing their effect on operations to a level within the company’s financial capacity. The company understands that sufficiently good financial results can only be obtained through controlled risk-taking.

 

Risk management at Suomi Mutual is a continuous activity. The company is prepared to change the contents and scope of its risk management to correspond to the company’s state and operating environment at any given time.

2.1.4 Risk management responsibilities

The company’s Board of Directors and President bear the overall responsibility for the company’s risk management. The Board of Directors annually reviews the risk management principles and approves a risk management plan covering the operations of the whole company. The company’s senior management is responsible for the implementation of risk management.

 

The risk management duties of Suomi Mutual have been scheduled to take place annually at regular times. Some of the risk management tasks are by nature such that they are carried out as part of the daily routines (e.g. several risk limits associated with the investment operations. The follow-up of identified risks has been entrusted to employees responsible for the area concerned.

2.1.5 Willingness to take risks

A crucial part of the company’s operating strategy is to decide what kind of risk and how much of it the company is willing to take on. This, naturally, has a direct connection with the solvency required of the company. For Suomi Mutual the timetable under which additional benefits will be paid is also important: the more risk the company takes, the more solvency capital operations require and the more the distribution of additional benefits has to be held back. On the other hand, if the company bears no risk, the insurances’ long-term return suffers.

 

The most significant part of the risks in terms of the company’s operations comes from the investment operations. This is a deliberate choice, since the company considers itself able to produce a competitive rate of return over the long term on the solvency capital invested in it. By acting thus, insurance policy holders will see the effect in the future through better additional benefits. As far as the biometric risks in the insurance operations are concerned, the risks are restricted to the existing portfolio, and the risks involved in it are managed by the company by means of internal risk analyses and reinsurance. As for the risks associated with operating expenses, the company has transferred management of the portfolio outside the company by means of various outsourcing agreements.

2.2 Measuring risks

2.2.1 Changes to official supervision

A new directive regulating the solvency of insurance companies (Solvency II Directive) is being developed by the European Union. The objective is that the Solvency II Directive will take effect in 2012. It will differ significantly from the current Solvency I Directive in its regulation of solvency. The most significant change is that the risks taken by the company in its operations will have a direct bearing on the level of solvency capital required (c.f. Basel II for banks). The calculation will be based on a financial perspective i.e. attempts will be made to value both sides of the balance sheet realistically. The aim of the Solvency II Directive is to set companies’ solvency requirement at a level that a company will remain solvent with a 99.5 per cent probability over a period of one year. This is the equivalent of the solvency of a company that has a BBB credit rating.

 

In the autumn of 2008, a new Insurance Companies Act took effect in Finland. The new law includes a section on predictive monitoring which will set objectives for limits to the company’s solvency capital. In the calculation model, the risks taken by a company will have a direct bearing on the solvency capital required, and the model is thus the first step towards the Solvency II Directive.

 

In spite of a changing world, the basis for insurance companies’ solvency monitoring will continue to be the laws and regulations in the Solvency I Directive. Solvency I is based to a great extent on book values and in practice only a company’s size affects its solvency requirement. The divergence in the technical provisions in particular will be considerable and among other things, will result in movements in interest rates leading to conflicting interpretations in terms of these directives. If interest rates rise, the value of interest-rate instruments in the Solvency I Directive falls and so poses a threat to a company’s liquidity. In the Solvency II Directive this will also have an effect on the technical provisions and because the maturity of a company’s liabilities is generally longer than that of the assets, a fall in interest rates will create a threat to a company’s solvency. Companies will, however, have to live with both sets of solvency regulations over the transitional period and each company will have to think which view will weigh more heavily. Suomi Mutual as a mutual run-off company has started from the point that it is of prime importance for it to be able to safeguard the insurance receivables that will end in decades without forgetting the overall return expectations for the entire portfolio, and has now decided to emphasise the financial perspective.

2.2.2 Company’s internal model

Suomi Mutual’s internal model is based on determining the financial capital needed by the company’s operations. This risk calculation model is based to a great extent on the model in the new Insurance Companies Act i.e. the risks are calculated modularly and they are totalled taking into account the joint effects of risks. Of the different risk factors, the following main kinds of risk and their sub-risks are considered explicitly:

 

  • Market risk
    • Equity risk
      • Developed markets
      • Developing markets
      • Risk capital investments
      • Other capital invesments
      • Hedge fund -sijoitukset
    • Interest rate risk
    • Real estate risk
    • Commodity risk
    • Currency risk
    • Counterparty risk
  • Insurance risk
  • Operational risk

 

Deviations to the official model include a reliability level to be aimed at (the company’s target is higher than official regulations) and the application of a risk-correlation matrix. The model has also been simplified in those parts where the significance to a mutual run-off company is small.

 

In its own model, the company applies factors calibrated to a reliability level of 99.5 per cent as risk parameters. A risk figure calculated with these factors is proportioned to the company’s risk-bearing capacity and in a normal situation the ratio must not exceed 80 per cent. In practice this means that the targeted reliability level of the company is the equivalent of the solvency of a company with an A credit rating.

 

The internal model also has a determining effect on the additional benefits provided by the company. The Board of Directors has confirmed the objectives regarding the distribution of additional benefits in the new Act and published them on its Internet pages and in the notes to the financial statements. In accordance with these objectives, the part of the solvency capital that is not required to bear risk at the reliability level set is distributed to policy holders as additional benefits. In determining the solvency capital required the internal model is applied. Adequate evenness in additional benefits is achieved by allowing the company’s solvency ratio to fluctuate within defined limits on either side of the basic solvency target.

2.3 Main risk factors

2.3.1 Investment operations

Part of the risks involved in investment operations can be managed with a calculation model which can measure the level of risks taken quantitatively. On the other hand, part are such that it is difficult to describe using a calculation model and they are more associated with operations. The risk factors that are measured quantitatively are listed below first.

 

Equity risk describes the risk of changes in values in equity prices for certain stresses (c.f. risk calculation section). Stress factors are specified separately for five markets that differ from one another: Developed markets, developing markets, risk capital investments, other capital investments and hedge funds.

 

Interest rate risk refers to the net effect that changes in assets and debts, resulting from changes in market interest rates, have on the company’s risk bearing capacity. This is clearly a central factor where there is dependence between assets and debts. As interest rates rise the value of corporate paper falls, but when provisions are calculated on a market basis then the value of liabilities also falls. The effect of change in interest rates depends thus on how assets and liabilities move together. Interest rate risk is measured assuming that rates rise/fall in parallel and the effect of this is calculated for both assets and liabilities. The risk factor is selected from rising and falling rates depending on which has the greater negative effect on the company’s risk bearing capacity.

 

Property risk describes the direct and indirect risks of changes in the value of property investments for certain stresses. Unlisted property companies whose main tasks is buying and renting property are also classified under property. Listed property investment companies are mainly classed under equity investments.

 

Commodity risk describes the risk of the change in value of investments in raw materials for certain stresses. As far as hedge funds that are separately defined as being raw material investments are concerned, the stress coefficient for commodity risk is applied.

 

Currency risk describes the risk of changes in value to investments denominated in foreign currencies resulting from fluctuations in exchange rates. The company’s investment plan sets target hedge levels for different kinds of assets.

 

Counterparty risk describes the credit risk arising from the counterparty to an interest rate investment, i.e. the risk that the counterparty will not be able to meet the financial obligations required under the contract.

 

The impact of the performance of the investment operations on the overall financial performance of Suomi Mutual is crucial. This can also be seen directly from the results of the risk calculation model applied by the company. Almost 90 per cent of total risk comes from the factors described above i.e. market risk. This market risk or the risk of change in investment value is measured using the company’s internal risk calculation model. In addition, there are other risk factors associated with investment operations which are described qualitatively below.

 

The Insurance Companies Act sets certain requirements for assets that can cover the company’s provisions. The company manages this by classifying its assets according to the criteria in the Act, and uses continuous monitoring to ensure that the assets covering the technical provisions fulfil the requirements set by legislation and the regulations issued by the authorities.

 

Investment operations have been outsourced with the exception of their control. The purpose of the control of the company’s own investment operations is to ensure that the outsourced operations fulfil the company’s objectives and that the operations are, in all respects, conducted within the limits of the investment plan determined by the company’s Board of Directors. The company’s own investment organisation is also responsible for ensuring that the outsourcing contracts are sufficiently secure from the company’s perspective.

 

In its investment operations the company favours instruments with risks whose nature can be clearly perceived and so it avoids complex structured risks. Furthermore, for the asset categories where the nature of the risk of individual investments may fluctuate considerably, reporting has paid special attention to reporting the risk in the entire asset category (e.g. hedge funds).

 

Derivatives are also actively used in investment operations. They can be used both to hedge market risks and to increase the level of risk. Derivative contracts are made on regulated markets or with such counterparties as have a sufficiently long-term credit classification. Instruments permitted are normal options, forward contracts, futures, swaps as well as other instruments approved separately by the Board. Exotic derivatives are prohibited in the main. Derivatives are taken into account in the company’s internal risk calculations.

 

The technical interest to be credited to customers’ insurance savings according to the insurance contract varies from 3.5% to 4.5%, depending on the contract. In addition to the technical interest, the company should be able to credit insurance savings with a competitive customer bonus, the amount of which is dependent on the customers’ reasonable return targets, the technical interest rate and the company’s profitability. The company’s objective is also to obtain a 12 per cent return on its solvency margin.

2.3.2 Insurance risk

Insurance risk is made up of the financial risks contained in the company’s insurance contracts which can be affected by changes in the level of mortality, lengthening of lifetimes, changes in working capacity and incidence of illness, increases or decreases in surrenders as well as changes in the level of expense loading. The level of these risks does not really change at all over the course of one year. These risks are also examined both quantitatively and qualitatively in the company’s risk management.

 

The risks in interest rate guarantees included in insurance contracts are included in the interest-rate category classed under market risk. The risk in question is estimated by generating forecasts about future technical-provision cash flows and calculating the present value of the cash flows obtained using different interest rate curves. In calculating present value the interest rate swap curve is used. Since the balance sheet date the company has implemented a new internal evaluation of what discount rate should be used in calculating the present value of provisions.

 

For biometric risks included in insurance operations (e.g. mortality), the adequacy of the technical provisions is screened continuously by means of various analyses. If necessary, the biometric assumptions used in the solvency calculation are revised to correspond better to the assessment of future developments. This risk is also associated with the level of insurance premiums for those lines of insurance in which the risk intensity according to the technical interest has turned out to show a deficit. In many of the company’s insurances the contract does not allow for increases in the premiums because of the deficit in the company’s insurance business. Because of the distribution of special additional benefits has started it is difficult to justify such increases even if the contract allowed them. Making sure the technical provisions are adequate creates the right basis for determining the additional benefits.

 

The most significant biometric risk affecting the financial performance of Suomi Mutual’s insurance operations is the longevity risk. The risk pertains to pension insurance. The pension periods in individual pension insurance are usually fairly short and they are mainly between the ages of 60 and 65 years. The insurance policies often include a death benefit, which reduces the significance of the risk of longer life expectancy. The pension benefits of group pension insurance last, on average, for a much longer period. They usually do not include a death benefit cover to compensate for the effect of increasing longevity. The mortality bases in group pension insurance have been changed in every respect so that they are determined on the basis of the year of birth of the insured. In this way, increasing longevity is taken into account effectively. The company monitors the development of life expectancy with various annual analyses.

 

On the other hand, the above-mentioned longevity risk is neutralised across the entire insurance portfolio when the fact that the company has a considerable number of death-benefit insurance policies is taken into account. As far as these insurances are concerned, the effect is the opposite. Of course it must be remembered that these risks concern different age groups.

 

Another risk relating to the insurance operations is the sufficiency of the company’s expense loading during the remaining period of the company’s operations. This is continuously monitored and, if necessary, the technical provisions are increased in a manner to ensure that the aggregate expense loading is sufficient.

 

The company’s insurance portfolio management systems are old and are based on rather old data processing technology. The systems function and are cost effective to use. It is possible that the technical environment of the systems will, at some point, have to be replaced with a new one. A survey carried out in the company shows that the safe usage age of the systems is, for the time being, long enough for there to be no need to replace them immediately. There is the risk that the systems will have to be replaced and this is being monitored continuously. The systems’ relatively old IT technology also increases staff-related risks concerning development and maintenance work.

 

Breakdown of Suomi Mutual’s technical provisions and the average duration of technical provisions in each insurance line are shown in the table below:

 

           
  Provisions
EUR million
2007		 Provisions
EUR million
2008		 % Those entitled to
special benefits		 Duration
Life insurance          
- Technical interest rate 4.5% * 1 236.7

1 191.5

23.6 %

98 %

9.8
Capital redemption contracts          
- Technical interest rate 4.5% * 195.9

8.5

0.2 %

0 %

-
- Technical interest rate 3.5% * 220.5

2 18.3

4.3 %

0 %

2.1
Deferred annuity insurance          
- Technical interest rate 4.5% * 2 612.6

2 583.3

51.2 %

75 %

8.4
Group pension insurance          
- Technical interest rate 4.5% * 3.7

3.9

0.1 %

0 %

-
- Technical interest rate 3.5% * 839.3

838.3

16.6 %

0 %

11.9
Other provisions          
- Technical interest rate reserve ** 320.4

122.0

2.4 %

-

-
- Expense loading reserve 35.5

36.2

0.7 %

-

-
- Other 43.6

44.7

0.8 %

-

-
- Future additional benefits 11.8

2.9

0.1 %

-

-
Total 5 519.9

5 049.4

100.0 %

  

9.0
           

.* = The discount rate for technical provisions is 3.5% in all policies, but contractual interest in some
        contracts deviates from this (4.25% or 4.5%).

** = In the technical interest reserve, the annual liability for the technical interest rate is
        covered to the extent that it exceeds 3.25%.

 

The company also tries to measure the above risks quantitatively. The company has calculated the effect on total liabilities of different scenarios. For the time being, the calculation of insurance risk in the company’s internal model is quite graphical and depends mainly on volumes.

2.3.3 Operational risk

Operational risk refers to financial losses that are caused by deficiencies in processes, information systems, people and above all by external events. The company’s risk management plan also includes risks related to outsourcing of operations, human resources, the company’s operating environment, steering and reporting.

 

The Insurance Contracts Act sets strict responsibility for the accuracy of information given by an insurance company to its customers. Even though Suomi Mutual no longer underwrites new business, the risk pertaining to this area is still significant. The risk concerns information given on contracts that are in force. Because of the significance of the risk, all written customer information is approved at Suomi Mutual before it is used, even in cases where the preparation and delivery of such information has been outsourced.

 

The day-to-day management of insurance policies has been outsourced. In accordance with the agreements, the company responsible for managing the insurances is entitled to develop the management processes, provided that the quality of management is maintained and that the financial performance of operations is not impaired as a result, for example, of simplifying the processes. The attainment of desired objectives through outsourcing is continuously monitored by following the development of the loss ratios and customer feedback.

 

A company engaged in operations similar to those of Suomi Mutual is mainly responsible for the outsourced functions. Therefore, Suomi Mutual must continuously identify potential conflicts of interest and avoid any problems caused by them. The quality of outsourced services is monitored by means of customer feedback and operational profitability. Outsourcing contracts are drawn up in a manner which minimises, as far as possible, risks related to their uncontrollable termination.

 

The scarce number of the company’s staff emphasises the importance of keeping the key staff members in the company’s service. By means of staff selection it has been possible to build the competence structure of the staff in such a way that the departure of a single staff member from the organisation will not cause any major problems. The number of staff does not allow for any further back-up arrangements. The company’s staff turnover is improved by enhancing staff commitment, for example, through a competitive overall salary structure.

 

Changes in the company’s operational environment, such as changes in insurance legislation, have only a limited effect on Suomi Mutual’s operations because the company no longer underwrites new business. The effects materialise mainly as increased costs, which is taken into account in the manner specified above in the section on cost-related risks.

 

It is important for the company to maintain a positive public image for the purpose of preserving customers’ trust in the company. Risks related to public image are managed through open and clear communication, which is mainly targeted at the company’s customers. A sufficient amount of communication is also directed at other groups interested in the insurance sector.

2.4. The company’s risk position

The company’s risk position is described by the results of the company’s internal calculation model. The table below describes the company’s risk position at the end of the financial year.

 

Line of risk

Risk contribution €M
(99.5%)

Equity

226

Interest rate

133

Real estate

129

Commodity

19

Foreign exchange

38

Credit risk

106

Diversification

-218

Market risk total

433

Insurance

70

Operational

15

Diversification

-55

Total risk

463
   

Risk bearing capacity

703

Risk ratio (maximum 80%)

66 %

 

 

The company’s risk position is a good descriptor of the company’s operating strategy for the near future. Risk levels are lower than a year ago and in accordance with its own operating principles, the company has the opportunity to increase its risk taking when it regards this as appropriate.