Martin Steward spoke to pension insurer Varma about how it manages its solvency levels and the impact Solvency II-style rules would have

"There are pro-Solvency II arguments," concedes Risto Murto, CIO at Varma, Finland's largest pensions insurance company managing €33.8bn worth of assets. "Regarding governance requirements and similar issues, I think Finland should at least think about what we might learn from Solvency II."

Beyond that, Solvency II is more a source of concern, than inspiration, to Finland's pension insurers - currently awaiting the conclusions of two working groups that will feed into new solvency and investment regulations due to come into force between 2012 and 2014. Phase one of the reforms was passed by Parliament earlier this year. These cover updated risk classification for credit and the values of the regime's investment group variables, among other things. The more extensive phase two is due for implementation in 2012.

"The working group has not yet delivered any specific suggestions," says Murto. "Obviously the big question for us is how far we will implement Solvency II-type principles. Luckily, at the moment, we do not have a Solvency II regime."

The Finnish regime has diverged meaningfully from the EU's capital adequacy regime. Varma's quantitative strategist, Kari Vatanen, singles out Solvency II's requirement that liabilities be discounted with market interest rates as most significant.

"If you want to match the duration of those liabilities any allocation to risky assets - equities, private equity, hedge funds - would have to dramatically decrease," he says. "The result would be a lower expected rate of return for the entire Finnish pension system - and therefore higher contributions."

It is for that reason that Murto remains ‘optimistic' about the consensus building against Finland adopting liability-accounting aspect of Solvency II for Finland's regime. "We are not fully funded as a society - the majority are still pay-as-you-go - so it would be sub-optimal to make pension funds ‘risk-free'," he observes. "Most agree that the system's parameters need to be calibrated so that they allow enough long-term risk taking."

Current market conditions make the point. Varma's fixed income portfolio went from 44% of total assets at the end of 2009 to just 34% at the end of H1 2011 - and within that, while the (floating rate) loans allocation stayed stable, bonds were halved and money-market instrument doubled, shortening duration dramatically.

"The negative real returns from bonds is a major challenge," says Murto. "We simply don't see any long-term value in holding sovereign debt. We find it difficult to understand why on earth anybody is holding Treasuries at the moment. As we don't have a liability-accounting structure in our regulations forcing us to hold these things we have minimized exposure."

Under the current regime, Varma held €7.9bn in solvency capital at the end of June, equivalent to 30.2% of its technical provisions and 2.2-times the minimum requirement. According to The Finnish Pensions Alliance (TELA), the aggregate result for all pension companies, company funds and industry-wide funds was solvency capital at 27.7% of technical provisions and 2.3-times the minimum requirement; for Varma's pension insurance company peers the aggregate solvency ratio was 2.2-times and solvency capital was 27.3% of technical provisions.

"Our target is to have a level of solvency capital that is best-in-class in Finland," says Murto. "However, the amount of risk that we take relative to the solvency capital requirements is more of a tactical issue for us. Therefore, while in absolute terms and in relation to our liabilities we have the highest solvency capital, we do not have the highest solvency capital ratio against the solvency requirements - that is, we do not have the most ‘risk-less' position in terms of portfolio positioning relative to solvency capital."

He describes how Varma deployed "extreme risk measurements" during the financial crisis - essentially focusing on equity to calibrate overall risk levels - which led to a successful defensive positioning implemented via a derivatives overlay. This left it holding solvency capital equivalent to 16.9% of its technical provisions, but a healthy 2.8-times the minimum requirement, at the end of 2008.

The pro-cyclical nature of Finland's solvency regulations - as solvency ratios rise, the return requirement also rises - meant that Varma was in a position to take more risk going into 2009, which it did, ramping up its equity allocation. At the same time, in December 2008, the authorities liberalised the risk charges associated with equity and loosened minimum solvency capital requirements for two years (renewed for the same period in 2010) to prevent Finland's insurers from having to sell their domestic holdings. (Under the old rules, Varma's solvency capital would be 25% of its technical provisions and 1.8-times the minimum requirement). As a result, Varma, and many of its peers, was able to participate in the next 18 months' of market recovery.

"That was very successful and it enabled us to increase our equity exposure more rapidly than otherwise," says Vatanen.

There is concern that, while the liability-accounting strictures of Solvency II are probably off the Finnish agenda, this kind of tactical flexibility on the assets side might be surrendered, as well as the Finnish regulations' more nuanced risk calibration for alternatives. With almost 40% in hedge funds, private equity, real estate and corporate loans, Varma could be exposed to any changes.

"It is possible that we may see Solvency II-type effects coming through that would impact the illiquid side of our portfolio," says Murto. "We are the biggest holder of real estate in Finland, and have 8% in private equity and 10% in corporate loans. If we see any indications that regulation is going in that direction - and it is not our expectation at the moment - that would affect how much new capital we could direct to those investments."