Investments

The investment environment favoured risk takers

Suomi Mutual posted an excellent market-based annual return on investments for the period under review. The annual return was 12.5 per cent. Without the change in the value of the swap basket hedging technical provisions the return would have been 12.4 per cent. The return was more than enough to cover the 4 per cent loss incurred in 2008.

What happened?

The year 2009 got off to a miserable start. As a result of the financial crisis, the banking system was paralysed and was only kept alive by central banks. Institutional investors wrestled with solvency problems, and instead of seeking returns concentrated on risk management. Risk premiums were record high and share prices plummeted. At the same time, gold price was up and interest rates reached new depths. Risk investments suffered from the lack of liquidity. Investors became scared.

However, the worst panic in the investment markets gradually receded. There was renewed confidence in the markets that massive government stimulus could prevent the downturn from developing into a prolonged 1930s-style recession and that the banking system would recover. Even though there were few positive signs in the real economy, the stock markets bottomed out in March and made a rapid recovery, which was boosted by market optimism. The investors had realised that, as a result of the crisis, the prices of equities and other risk investments had reached unreasonably low levels. Risk takers returned to the markets and were provided with an unique opportunity to earn huge monthly returns.

The underlying market sentiment remained positive until autumn. Share prices recovered and share values again returned to more or less neutral levels. The real economy was, however, still in trouble. At the end of the year, there were worries that countries might not be able to manage the enormous debts which they had accumulated within a short period of time. It was feared that the stimulus which had greatly helped the financial sector would have to be terminated prematurely, which would deny the real economy the boost that it was expecting to get. As a result, the rise in share prices slowed down and uncertainty increased again.

In retrospect, the investment environment of 2009 was, after the turnaround in March, relatively trouble-free. However, the technical analysis had a major influence on the interpretations. Liquid instruments closely followed market trends. Investors only needed to believe what they saw and increase their risk levels as the risk-bearing capacity improved in tandem with rises in equity prices. Risk management using a variety of stop-loss strategies was relatively easy.

The assessment of the situation was also made easier by the fact that the course of events was more or less in accordance with previous cycles. Asset classes recovered one by one and in more or less the same order and along the same timetable as before. History repeated itself and those who had suffered losses in 2008 made profits in 2009. For this reason, it was more or less inevitable that 2009 was a successful year for equities, hedge funds and fixed-income investments involving credit risks; in other words, for all those asset classes and investment types that have recovered first in previous upturns. The fact that post-cyclic sectors (real estate and private-equity investments) would suffer in 2009 was also foreseen. In Finland, the housing market was actually the only exception to this picture. Unlike in previous cycles, it only experienced a slight dip and recovered more rapidly than expected. However, there were clear reasons for this development. Builders had acted cautiously, which meant that new construction had decreased so much that not even a rapid rise in unemployment could prevent a rapid recovery in housing prices.

The year 2010 has also gotten off to an uncertain start. Problems with the real economy remain substantial, particularly in the highly developed western world. Even though the worst is almost certainly over, growth expectations for western countries are modest. Growth will remain slow. Unemployment has not yet peaked and government deficits can only be tackled through tax increases and cuts in income transfers. Private consumption is suffering from the lack of private investment. All of this means that the western economies will not recover from the downturn any time soon. Moreover, investors may no longer be eager to take risks. The technical picture for the markets at the start of 2010 was also confusing.

Efforts to increase investment risk successful

The return on Suomi Mutual’s investment operations in 2009 was extremely good and clearly far better than expected. Both relative and absolute targets were achieved. It is noteworthy that the annual return of 12.5 per cent was more than enough to cover the losses of the previous year (-4.0 per cent). This means that the company identified its market base correctly and chose the right moment to increase its risk levels.

Most of the increases occurred in equities and were made by gradually dismantling derivative hedgings. Share allocations were increased from slightly less than 10 per cent (in March) to about 28 per cent (at the end of the year).

The return for 2009 amounted to EUR 713 million (EUR -267 million). This figure includes the positive result of EUR 6 million from the swap basket taken for the purpose of hedging technical provisions. Without the swap basket, the total would have been EUR 707 million. The result was substantially in excess of the targeted return of EUR 120 million, which had been derived from the requirements set for the return on technical provisions, competitive customer bonuses and the market-based return on equity.

The company also distributed a substantial amount (EUR 161 million) as customer bonuses for 2009. The company’s solvency nevertheless remained strong at the year’s end and its capacity to bear investment risks was good.

When examining the following figures on returns for individual asset classes, one should note that the asset classification used by the company in its internal reporting is slightly different from the system used by the authorities.

Suomi Mutual’s investment operations were also successful when compared with overall market trends. Fixed-income investments yielded particularly high returns. Returns on credit-risk, investment-grade and high-yield loans rose substantially as a result of positive value adjustments and risk increases. For example, even though high-yield loans had a relatively low allocation (7 per cent), they generated a return of EUR 163 million (47.5 per cent). Fixed-income investments (including investments in convertible bonds) yielded an overall annual return of 12.8 per cent, compared with the return of 4.9 per cent generated by the benchmark index consisting of risk-free government loans and money market investments.

Equity investments generated a return of 29.3 per cent (EUR 286 million), which was more or less in accordance with the market trends. Investments in emerging markets were the top performers, generating a return of 81.6 per cent. Because of their post-cyclic character, private equity investments generated a negative return of 18.4 per cent (EUR 54 million). At the start of 2010, as this review is being written, there no longer seems to be any need for private equity investment write-downs, and in fact, the opposite has already happened in a small number of funds. The recovery of private equity investments is likely to continue. The company no longer makes private equity investments.

In real estate investments, the company fell short of its target of 5.3 per cent. In overall terms, the company’s real estate investments generated a negative return of 1.5 per cent (EUR -10 million). The year was particularly difficult for real estate funds. They generated a negative return of about ten per cent. However, as in private equity investments, there will probably be substantial value recoveries in real estate funds. At this stage, the problems in the investment environment did not have any impact on the direct real estate portfolio. At the year’s end, the real estate portfolio was more or less evenly divided between indirect funds and direct holdings. The company no longer makes investments in real estate funds. At the end of the year, real estate investments accounted for about 10 per cent of the balance sheet.

At the same time, some 4 per cent of the investments were in hedge funds. These investments, too, generated high returns (16.4 per cent or EUR 35 million). For these investments as well, the results were partially based on cancelled write-offs.

Commodity investments only accounted for 0.2 per cent of the total at the end of the year. The company no longer makes investments in commodities.

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 the new guidelines, 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 generates 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 is sought from equity markets. When pursuing these targets, the company must never allow the investment risk to exceed its own 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. In 2009, the company’s business operations were initially characterised by efforts to keep risks at manageable levels but, as the year progressed, achieving returns became increasingly important.

Revolution in investment operations

For many years, the purpose and the main objectives of Suomi Mutual’s investment operations remained unchanged, despite changes in the structure of the investment portfolio and the balance sheet. The company managed its investment operations with a long-term approach, securely and productively but at the same time in accordance with the principles guiding investment activities. 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, at the time the company’s technical provisions already contained a significant interest risk, the impact of which on the company’s solvency was overlooked.

As of 1 January 2008, Suomi Mutual started to value technical provisions in accordance with the fair-value principle in its internal accounting. This was in accordance with new and planned official regulations (the new Insurance Companies Act and Solvency II). The change was highly significant and had a substantial impact on the objectives of investment operations and the way in which the operations are steered. 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 directly affecting the company’s 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.

In 2009, it became clear that drawing up the Solvency II regulations will be a long and difficult process. It is not easy to reconcile theory and practice and many details still need to be ironed out. There have also been disagreements, and compromises are needed. The project is nevertheless making progress and compromises will hopefully lead to a better end result.

The investment plan and the risk-management plan guiding operations

The investment operations of Suomi Mutual are guided by the investment plan approved by the Board of Directors. The method for measuring and calculating the risk-bearing capacity and investment risks is laid down 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 in the plan.

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 partners. Pohjola Asset Management Ltd provides the accounting and reporting services required by Suomi Mutual in its investment operations. Pohjola Property Management Ltd, acting on its own or through its subcontractors, is responsible for the operational functions covering 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.