Market risk is the fluctuation of the value of investments. The greatest market risk is that involved in equities. Other market risks are the interest rate risk, foreign currency risk, and the value change risk of real estate objects. Interest rate risk can be realised as a price risk, or as a reinvestment risk.
Inflation risk is the decrease of the real value or return of assets.
Credit risk is a danger of loss caused by the inability of the counterparty to honour its commitment.
Liquidity risk is the realisation of cash flow at a different amount than expected. A risk is also constituted by investments that cannot be converted into cash at all or can only be converted at a major loss. In the management of liquidity, any guarantee commitments must also be taken into account. Liquidity disturbances in the banking system are also mirrored in Varma’s liquidity.
Concentration risk refers to the increase in market, credit and liquidity risks as a result of insufficient diversification of the portfolio.
The model risk is constituted by the risks involved in risk measurement. In measurement it is necessary to make assumptions and simplifications concerning calculation methods and calculation materials, which may deviate from reality. There may also be risks related to the valuation of investments, and some of the investments’ values are available with a delay.
Investment risk management makes use of calculation assumptions and the regulations governing technical provisions and solvency, among other things. Solvency regulations will undergo renewal as of 1 January 2017, and at the same time the separate regulations on technical provisions will be removed. This change is not expected to have any major influence on Varma’s risk-bearing capacity.
Management of investment risks involves the determination of acceptable risk levels for different investment categories within the framework approved by the Board of Directors, continuous risk measurement using selected methods (different indicators used in risk management, market information and analyses, computer applications), comparison with acceptable levels, and reporting. Risk management also involves adaptation of the investment portfolio so that a correct risk/return ratio can be maintained. The nature of technical provisions and their return requirement are also taken into account when the time span and liquidity of investments are considered.
The investment plan approved by the Board of Directors defines, among other things, the following:
- the general security goals set for investments,
- the general principles for investment allocation,
- the return, diversification and liquidity goals of investments,
- the criteria for using derivative contracts, and
- the principles for arranging foreign currency business.
At least once a year, the Board of Directors assesses the status and outlook of Varma’s operating environment, the investment risks in terms of changes in value, expected returns, security, and the foreign currency business, and the company’s short-term and long-term risk-bearing capacity and the development of the company’s solvency position.
The basic allocation of the investment portfolio laid down in the investment plan approved by the Board of Directors also lays down the basic level for the total portfolio risk. The investment portfolio may differ from the basic allocation within the allocation limits specifically defined in the investment plan.
Varma aims to maximise the yield expectation at the selected total risk level, which means that investments will have optimum profitability to the extent allowed by the company’s risk-bearing capacity. Active risk targets have been laid down for different asset classes and items within which Varma is making active investment efforts to produce returns above the market index. The portfolio’s realised market risks, active risks and returns generated by active investments are regularly monitored and reported in Investment Operations.
Varma’s investment portfolio’s structure by asset class and returns by asset class for 2015 are presented in the Notes to the Financial Statements.
Geographical allocation of investments in listed equities:
Direct investments in real estate according to purpose of use:
The vacancy rate of business premises was 7.2% (7.3%).
Bonds according to credit rating:
Loans by type of security are presented in the Notes to the Financial Statements under Loan receivables.
Furthermore, Varma takes into account the corporate responsibility principles of investment allocation, and the share ownership principles in which, among other factors, high-quality governance and the operational transparency of domestic and foreign companies are important selection criteria in making investment decisions.
The market risk of investments, mainly equities, constitutes the biggest risk relating to the result and solvency. The VaR (Value-at-Risk) figure, which measures the total risk of Varma’s investments, stood at EUR 1,842 million (EUR 1,492 million) at year-end 2015. The figure indicates the greatest possible fall in the market value of the company’s investment portfolio in ordinary market conditions over a period of one month at a probability of 97.5%. The CVaR (Conditional Value at Risk) figure refers to expected losses exceeding VaR, and this figure amounted to EUR 2,197 (1,779) million.
The total risk relating to investments is adjusted to the company’s risk-bearing capacity in such a way that the company’s solvency position is not endangered. The maximum risk level is measured such that even after a 25 per cent drop in the value of listed equity investments and certain hedge fund investments, the solvency capital still exceeds the minimum solvency capital (1/3 of the solvency limit) by at least the amount of the VaR and is, in any case, always at least at the solvency limit. The restrictions that apply to different investment categories are also taken into account when calculating the assets covering the technical provisions.
The different maximum limits of investments are presented as separate risk limits in the investment plan. The diversification of the investment portfolio is based on allocation that takes into account the return correlations of asset classes.
Investment risks can be abated and eliminated, for example,
- by diversifying investments by asset class and item,
- by analysing the investment portfolio and items,
- by avoiding risk concentrations,
- by limiting the amount of unlisted securities,
- through a securing guarantee policy,
- through careful valuation practices,
- by integrating assets and liabilities,
- by using derivatives,
- by applying adequate and on-time supervision and monitoring arrangements, and
- by minimising counterparty risks.
The risk limits and authorisations laid down in the investment plan are monitored by the Investment Operations both before and after assignments. In addition to analyses of investment markets, Varma monitors matters such as investment duration, classification and liquidity. In real estate investments, Varma pays special attention to technical and location risks, among others.
New investment instruments with return and risk profiles that are significantly different from the instruments contained in Varma’s present portfolio are examined by the Investment Committee and are also presented to the Board of Directors before being applied. The realised risks of the investment instruments with return and risk profiles that differ from those normally used are examined regularly. Following the examination, the investment instruments are given a solvency classification that is in accordance with their actual risk.
The table below shows how falls in equity prices and real estate values and increases in interest rates would affect return and solvency figures in the financial statements.
The investment diversification requirement is a central part of the company’s technical provisions and solvency regulations. When the solvency limit is calculated and the assets covering the technical provisions are listed, investments are categorised into solvency groups. Under the regulations, euro-denominated derivative authorisations and the permitted maximum loss must be determined, and derivative contracts must be classified in risk-lowering and other than risk-lowering contracts. Varma’s largest individual corporate risk position is its equity ownership in Sampo Plc, the market value of which was EUR 1,672 million on the closing date.
The Board of Directors decides on the principles concerning the use of derivative contracts and the principles for the solvency classification of investments. Based on a proposal by the Chief Investment Officer, the CEO decides on the risk classification of investments and the actuary function’s independent investment risk manager will give an opinion on the proposals. Solvency classification is reviewed on a regular basis. The Board of Directors receives an independent monitoring report on the adherence to the classification criteria, and on the use of derivative contracts and the impact this has on the solvency limit.