Solvency regulation restricts risk-taking among pension providers
One of the tasks of private-sector pension providers is to place part of the annually collected pension contributions into funds. The assets placed in funds are invested and the returns received increase the value of the funds. The investment activities of pension providers, however, are strictly regulated. The key regulations are associated with solvency and set conditions for the investment of earnings-related pension assets.
Solvency describes an operator’s ability to cope with risks
The solvency of earnings-related pension providers refers to their ability to cope with the risks encountered in pension insurance activities. Risks are an inherent element of these activities, and may relate to both investments and underwriting proper. Regulation concerning solvency is used to determine the risk level permitted for the investment of earnings-related pension assets, and thus also provides the framework for the returns sought in investment activities.
By law, pension assets must be invested profitably and securely. In practice, this requires a balance between return-seeking and risk-bearing capacity. High returns and a low risk level are contradictory goals by nature. The greater the investment risks are, the higher are the returns that may be obtained. Correspondingly, the less risk one is willing to take, the lower the return on assets will be.
The regulations on solvency only pertain to private-sector pension insurers, i.e. pension insurance companies, company pension funds and industry-wide pension funds, as well as the Seafarers’ Pension Fund and, to some extent, the Farmers’ Social Insurance Institution of Finland.
In the public sector, investment activities are guided by decisions, made in the decision-making bodies of pension providers, concerning how investments can focus on different investment categories.
The purpose of regulation is to secure pension assets and benefits
The solvency of private-sector pension providers is regulated by law (Act on the Calculation of the Solvency Limit of a Pension Provider and the Diversification of Investments). The purpose of regulation is to secure pension assets and — in the end — earnings-related benefits. In addition, regulation acts as a framework for the earnings-related pension system to address excessive risk-taking where necessary. The possibility of intervening in excessive risk-taking is important because of the joint and several liability for bankruptcy among private-sector pension providers.
Solvency regulation, in part, affects how much risk earnings-related pension providers can take in their investment activities. However, investment activities are also steered strongly by the earnings-related pension provider’s other risk management. Thus, solvency regulation does not prevent pension providers from making as productive investments as possible, while taking into account the level of security.
The Financial Supervisory Authority is responsible for supervising the solvency of pension providers.
A solvent insurer fulfils its obligations even when risks materialize
The pension provider calculates the technical provisions for each insured employee and pensioner insofar as the pension provider has put assets into funds in advance for their pensions. Technical provisions are determined so that they will be sufficient, on average, for paying the funded part of the pension.
Solvency is measured by determining the pension provider’s assets that exceed the technical provisions. If the investment assets exceed the technical provisions to a sufficient extent, the pension provider is considered to be solvent. This means that the pension provider is able to meet its obligations related to pension insurance activities, even if some of the risks related to insurance activities materialize.
The assessment of solvency is based on the definition of the risk level in investments made by pension providers, on the assessment of underwriting risks and on mathematical calculations made on the basis of these.
Key figures as indicators of solvency
The solvency of pension providers is described by using various key figures, the most important of which are solvency capital, solvency position and solvency ratio. A fixed solvency limit associated with the solvency capital is defined separately for each operator.
Solvency capital and solvency limit
Pension providers can prepare for investment and underwriting risks by using their solvency capital. Solvency capital includes, among other things, equity, valuation differences on investments and buffer funds for risks.
Company and industry-wide pension funds have the option of including in the solvency capital a separate item based on the employer’s obligation to pay an additional contribution. This item can be used to strengthen the pension fund’s risk-bearing capacity.
In order for a pension provider to be solvent, its solvency capital must exceed the solvency limit. The solvency limit is a value calculated on the basis of the structure of the pension provider’s investment portfolio, to which the solvency capital is compared. The general rule is that the greater the risks involved in the pension provider’s investments are, the higher is the solvency limit required by the regulations.
By applying risk theory, the solvency limit is defined so that it corresponds to one year’s need for solvency capital, taking into account both the risks of the underwriting business and the risks of investments. The solvency limit is calculated on the basis of the entire investment portfolio. When calculating the solvency limit, pension providers must identify the risks associated with each investment, as well as the underwriting risk. Risks are taken into account in accordance with the risk character prescribed by law. One and the same investment may be subject to many different risks. The expected return on investments and the interdependence between various risk factors are also taken into account in calculations.
By law, investment risks are divided into 18 categories:
- Risk categories 1–5: equity risk
- Risk category 6: interest rate risk
- Risk categories 7–10: credit margin risk
- Risk categories 11–12: real estate risk
- Risk category 13: currency risk
- Risk category 14: commodity risk
- Risk category 15: required rate of return risk
- Risk category 16: underwriting risk
- Risk category 17: residual risk
- Risk category 18: other risks
In addition, the solvency model takes account of
- market risks
- the counterparty risk
- the concentration risk
- the leverage ratio, and
- risks associated with derivative contracts and indirect investments.
The calculation model enables increasingly flexible preparation for the development of investment instruments. If necessary, new risks can be added to the calculation.
If the solvency capital of a pension insurance company exceeds the solvency limit, or if the solvency capital of a company pension fund or an industry-wide pension fund exceeds the solvency limit by a factor of 1.3, no extra restrictions are imposed on the pension provider’s activities.
If the pension provider’s solvency capital falls below the solvency limit, the pension provider must submit a plan for improving its financial position to the Financial Supervisory Authority. If the pension provider’s solvency capital falls below the minimum capital limit, the pension provider must submit a plan for improving its financial position to the Financial Supervisory Authority.
Solvency ratio and solvency position
The solvency ratio shows by how much the pension provider’s assets exceed the technical provisions. For example, a solvency ratio of 130% indicates that the pension provider’s assets are 130% of the amount of technical provisions.
The solvency position, in turn, illustrates the solvency capital in relation to the solvency limit. For example, if the solvency position is 2.0, the pension provider’s solvency capital is twice the solvency limit.