Review by the President and CEO

The mission of Suomi Mutual is to manage the insurance and related investments of its existing customers. As a mutual company our sole purpose is to act for the benefit of our customers. In investment operations our aim is to obtain the best possible return permitted by our risk-bearing capacity, while at the same time maintaining operational efficiency.

We distribute our annual operating profit and the solvency capital released through maturing insurance policies to our customers as additional benefits to the degree permitted by our risk-bearing capacity. We endeavour to reconcile our additional benefits and solvency so that insurance policies of different lengths are treated as even-handedly as possible.

In 2008, Suomi Mutual fell substantially short of its targeted result

We already estimated at the start of 2008 that there would be challenges during the year and were prepared for a weaker investment environment. However, the financial crisis that came to a head during the autumn made the situation much worse than we had anticipated. Equity prices fell to almost record lows and market volatility reached extremely high levels. Risk premiums for corporate loans increased to very high levels, resulting in a record number of bankruptcies. Investments that took advantage of easy credit lost a substantial proportion of their values as drops in asset values led to tighter lending.

We had prepared for a drop in equity prices by drawing up a plan for hedging our equity portfolio. The plan worked reasonably well and thus we were able to substantially decrease the negative return on our equity investments. We consider this a major achievement. We had less success in fixed-income investments. Our fixed-income portfolio contained a substantial number of corporate loans. The increases in risk premiums for these loans meant that the return on our fixed-income investments was negative. Even though the return on real-estate investments was positive, decreases in the values of indirect real-estate investments meant that we fell short of our targets. Return on alternative investments, hedge funds and commodity investments was negative.

The total return on the investments described above was -8.7 per cent, which was more or less in keeping with our benchmark indices. In addition to the factors above, the final investment return was also impacted by the return on the interest-swap agreements hedging technical provisions. It was high and, if included in the final figures, would push the overall return to -4.0 per cent.

The return target for our investments is determined by our insurance operations. We fell substantially short of this goal and therefore, in our view, the result for 2008 was poor. However, compared with other companies in the same business, the result can be considered satisfactory.

Our operations were guided by changing solvency requirements

The EU is preparing changes to insurance companies’ solvency requirements (Solvency II). Compared with the existing legislation, the new solvency requirements would be more in line with each company’s own risks. In Finland, the revised Insurance Companies Act came into force at the start of October. It means that Finland can already start harmonising its supervision practices with the Solvency II requirements before the introduction of the new EU legislation.

In principle the new legislation is a step forward. However, it will also mean problems, particularly on the debt side of the balance sheet. In official financial statements the technical provisions will, for the time being, be calculated using the existing principles, and testing of the solvency will be based on existing requirements. In the future, technical provisions will be measured at fair value by discounting estimated future cash flows using the market rate yield curve. As regards major changes in interest rates, the new and existing regulations will operate in contradictory directions. The solvency levels measured using the two different operating methods may be substantially different. My view is that insufficient attention has been paid to this problem during the preparation of the new legislation. There should be a flexible transition to new improved monitoring procedures so that companies and their clients do not need to face any unnecessary discontinuities.

Suomi Mutual has been preparing for the new monitoring framework for some time. Since the beginning of 2008, we have been controlling our operations in a way that is close to the new requirements. We have aimed at a solution in which the control system takes into account our most significant risks as well as possible.

We were able to learn more about the practicalities of the new monitoring framework and its impacts during 2008. During the early part of the year, market rates increased and the interest-swap agreements we had used for hedging technical provisions lost some of their value. As the shrinking of technical provisions resulting from higher interest rates is not shown in the official financial statements, officially our solvency decreased. During the latter half of the year, the trend was the opposite.

An exceptional year demonstrated the problems contained in the new requirements

In certain countries technical provisions are already, at least partially, defined in a market-based manner and this principle is to be extensively adopted as part of Solvency II. As a result of the drop in investment values many of the operators supervised in this manner decided to increase the hedging of their technical provisions more or less simultaneously. Hedging is often made using a variety of interest-swap agreements. It is difficult to find natural counterparties to long-term agreements. Simultaneous increases in hedging led to a substantial drop in the interest rates used in the agreements. For us, it meant an increase in the value of interest-swap agreements we had already concluded. As it is not yet necessary to calculate technical provisions using the market-based method, we benefited greatly from these developments. The rises in the value of the interest-swap agreements helped to improve our interest returns and our solvency position as calculated in accordance with Solvency I.

This raises a number of concerns. What will happen if all European insurance companies are forced to adopt the new monitoring framework within a short time span? There are no real markets for technical provisions and, at least in the short run, they will only be generated through crises. The market-based nature of the technical provisions is solely derived from the market-based nature of the discount rate used in calculating them.

The developments during the last year alone show that adopting this method will lead to highly volatile technical provisions unless interest-derivative markets expand substantially. I do not think that there will be any natural counterparties for long interest derivatives if a large number of institutional investors are more or less simultaneously forced to use them.

Are we actually generating yet another new system increasing economic volatility by introducing well-meaning requirements? My understanding is that in the view of many parties, the Basel II requirements applying to banks and the IFRS accounting standards, which do not only apply to the financial sector, have the same impact. The purpose of the solvency requirements is to secure the interests of the insured. Will this be the case if the companies must, in order to hedge long-term interest rate risks, fix their interest returns at 2-3 per cent for the next 50 years?

I am not denying that the Solvency II requirements are in many respects better than the existing ones. However, in my view, to the extent that the requirements are ‘market-based’ simply by definition rather than being related to real markets, is something that should be changed. If there are no real markets, it is better to settle for less dogmatic requirements that do not lead to distorted market reactions and, consequently, have negative impacts on many well-functioning markets.

Few additional benefits distributed

Suomi Mutual distributed about one billion euros in additional benefits to its customers for 2005-2007. Less than EUR 10 million was distributed in additional benefits for 2008. Additional benefits were now only given to insurances in which the minimum return under the insurance contracts is lower than in other contracts.

When preparing for the decision, it was more or less impossible to make any short-term predictions. For this reason we concluded that maintaining solvency at as high a level as possible would be in the best interest of policyholders. A high level of solvency is the best guarantee for insurance savings, should the negative trend continue. It will also allow the company to seek higher returns based on controlled risk-taking as soon as the investment markets start recovering.

Difficult to predict trends in 2009

At the start of 2009, the risk-bearing capacity of Suomi Mutual is at least highly satisfactory and, compared with many other institutional investors, even good. We have, however, lowered the weighting of equity investments in our basic allocation. The short-term uncertainty is a bigger challenge for the year 2009 than the state of the company. At this stage, it is extremely difficult to predict what will happen on the investment markets or in the economy as a whole. Suomi Mutual is also in a position to take more risks as soon as there are enough positive signs on the market. If that happens, risk-taking will be gradually increased and any results generated will be used for additional customer benefits and to strengthen solvency and, consequently, a controlled increase in risk-taking. In the near future, even if the trend were to be positive, the total amount of additional benefits will probably be lower than during the past few years.

Even as the economic crisis has worsened, our customers have remained calm. The number of surrenders has not risen above ordinary levels, and the substantial cuts in additional benefits has brought little negative feedback. I would like to thank our customers for this attitude. Despite the problems we are facing, the future at our company looks good. The crisis will come to an end one day and after that high returns will once again be paid on insurance savings.

Cooperation with the administrative bodies has continued to be good. For this, I would like to thank the members of the Board of Directors and the Policyholders’ Representative Assembly, which functions as the General Meeting. Our personnel, though small in number, have performed well in a difficult situation. Likewise, our partners managing our insurance and investment portfolios have been efficient in their work and the spirit of cooperation has been good. I would like to express my thanks to our own personnel and to our partners as well.

February 2009

Markku Vesterinen
President and CEO