## 1finea2023006

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---

### Executive summary — overview and context
- Evaluates non‑bank financial institutions (NBFI) in Finland with special focus on pension insurance companies (PICs).
- Analysis set against the backdrop of: the war in Ukraine, the energy crisis, rising central bank interest rates amid a sustained inflationary surge, and the aftermath of the COVID-19 pandemic.

### Size and composition of the NBFI sector (end-2021)
- Statutory earnings-related pensions (private sector): EUR 161 billion (bulk in PICs).
- Earnings-related plans for public sector and specialized regimes: EUR 94 billion.
- Total insurance assets: EUR 89.6 billion (life: EUR 73.0 billion; nonlife: EUR 16.6 billion).
- Fund management sector assets (AUM): EUR 180.0 billion.

### Recent performance and market events
- NBFI sector faced fewer challenges during COVID-19 and the war in Ukraine than during the Global Financial Crisis due to improved risk management, lower customer withdrawals, and increased demand for savings products.
- Strong market recovery after Q1 2020 and exceptionally strong investment returns in 2021 boosted insurer and PIC capital positions.
- COVID-19 caused temporary fund suspensions with total assets of EUR 3.5 billion; a small number of Russia‑focused funds were suspended and subsequently closed.

### Supervisory interaction and regulatory burden
- Market participants value FIN-FSA engagement during crises but note extra resources and expertise would be useful.
- Pace of new EU-driven regulation creates costs and uncertainty; faster national regulations and more FIN-FSA support recommended.
- Recommendation that FIN-FSA publish a detailed annual supervisory plan to help industry prepare for regulatory changes and EU Common Supervisory Actions.

### Insurance sector solvency and vulnerabilities
- Solvency strong overall aided by:
  - High profitability in nonlife (COVID-19 reduced claims).
  - Strong asset returns in 2021.
  - Rising interest rates in 2022 (liabilities declining even as asset markets fall).
- Warning: rising solvency from interest rate increases can create misleading signals of sector strength.
- Vulnerabilities: sharp interest rate reversal, further equity market falls, or local real estate correction.
- Conduct‑of‑business risk: high profits and relatively high charges in investment funds and unit‑linked life products.

### Macroprudential policy and disclosure
- FIN-FSA’s macroprudential strategy now includes NBFI, but BoF and FIN-FSA publish little on these issues despite insightful internal analysis.
- Uninvestigated domino risk channel: exposures across energy companies, banks, construction firms, and high‑energy‑demand firms related to the war in Ukraine.

### Sustainable Finance Disclosure Regulation (SFDR)
- Market requests forward guidance on SFDR and dialogue with ESMA/EU to ease implementation in stressed markets.
- Access to good quality ESG data is challenging; potential short‑term FIN-FSA regulatory forbearance could be useful.

### Pension Insurance Companies (PICs): role and systemic importance
- PICs are part of the mandatory social security system and invest assets to partly fund the system.
- Sensitivity: an increase of 1 percent in real returns on EUR 160 billion assets is equivalent to 2 percent of wages in contributions.
- PICs are not subject to IORPII or Solvency II, giving Government of Finland and FIN-FSA greater domestic regulatory freedom.

### Recent PIC performance and structural features
- PIC average returns in 2021: +16 percent.
- PIC assets fell in H1 2022: -6 percent (not considered a stability issue).
- System features:
  - No individual customer ability to sell assets; transfers by employers affect only new contributions.
  - Open mandatory system with close to 25 percent of wages paid each month into the system.

### Investment strategy, past behavior, and comparators
- Over 20 years, PICs diversified into illiquid assets (real estate, private equity, higher‑quality hedge funds) consistent with long-term liabilities.
- Performance: lower than regional comparators over 1998–2021 (particularly 1998–2017) compared to the local government fund that invested countercyclically.
- Evidence of procyclical and herding behavior driven by solvency regulations:
  - Major PICs acquired or sold listed equity in a highly correlated manner; correlation between them now surpasses 80 percent.
  - PIC allocation became more similar to public pension funds after 2014 and 2017 loosening, with greater than 90 percent correlation since 2015.
  - Historically (1999–2017) PICs often sold equities procyclically in response to negative shocks while public pension funds invested countercyclically.

### Regulatory and supervisory implications for PICs
- 2017 solvency reforms reduced procyclicality but regulations remain too short‑term focused, detracting from long‑run performance.
- Recommendations:
  - Amend solvency regulations to remove remaining procyclical effects and develop new short‑term liquidity rules.
  - Develop a liquidity regulation so PICs have sufficient buffers for extreme events.
  - Run crisis simulation exercises for a large PIC failure covering policy response, market impact, funding response, and operational implications.
  - Increase FIN-FSA supervisory resources for governance, investment, and operations oversight; rebalance resources away from low‑risk tasks.
  - Consult on increasing fees to enhance supervisory resources.

### Market conduct and costs
- Take a more proactive role on total costs given significant fee levels in the fund sector, unit‑linked insurance, and very large nonlife insurance profits.

### Key quantitative signals and metrics (as stated)
- PIC assets (used in 1 percent sensitivity): EUR 160 billion.
- Impact of 1 percent increase in real returns on EUR 160 billion assets = 2 percent of wages in contributions.
- PIC average returns in 2021: +16 percent.
- PIC asset decline in H1 2022: -6 percent.
- NBFI fund suspensions during COVID-19: EUR 3.5 billion.
- Sector asset totals (end-2021):
  - Private statutory earnings-related pensions: EUR 161 billion.
  - Public sector and specialized regimes: EUR 94 billion.
  - Insurance total: EUR 89.6 billion (life: EUR 73.0 billion; nonlife: EUR 16.6 billion).
  - Fund management sector: EUR 180.0 billion.
- PIC correlation in listed equity decisions: now surpasses 80 percent.
- PIC investment allocation correlation with public pension funds: greater than 90 percent since 2015.
- Share of wages paid monthly into the open mandatory system: close to 25 percent.

### Recommendations (summary of Table 1: Finland: Recommendations on Non‑Bank Financial Intermediation)
- Amend PIC solvency regulations to remove remaining procyclical effects and develop new short‑term liquidity rules. Agencies: MoSAH; FIN-FSA. Timing: NT.
- Publish an annual supervisory plan for the NBFI sector. Agency: FIN-FSA. Timing: I.
- Enhance public disclosure of analysis and assessment of macroprudential risks in the NBFI sector. Agencies: BoF; FIN-FSA. Timing: I.
- Reduce resources devoted to low‑risk issues (technical advice, registrations) to free resources for higher risk areas. Agency: FIN-FSA. Timing: I.
- Provide continued forward guidance on SFDR timing and actions and dialogue with ESMA/EU to ease implementation in stressed market conditions. Agency: FIN-FSA. Timing: I.
- Consult on an increase in fees to enhance supervisory resources. Agencies: MoF; FIN-FSA. Timing: NT.
- Enhance market intelligence on NBFI trading (including daily) to better monitor crisis experiences. Agencies: BoF; NBFI. Timing: NT.
- Take a more proactive role on total costs across funds and unit‑linked insurance. Agency: FIN-FSA. Timing: NT.
- Conduct a crisis simulation for the orderly resolution of a major PIC, involving FIN-FSA; MoSAH; ETK; RVV. Timing: MT.
- ETK to conduct a cyber risk crisis simulation with PICs, KEVA, and KELA. Agencies: ETK; PICs; KEVA. Timing: NT.
- Timing codes: I = Immediate (within one year); NT = Near Term (within 1 to 3 years); MT = Medium Term (within 3 to 5 years).

### Analysis of life and nonlife insurance and fund management sectors (highlights)
- Market structure and concentration:
  - Top four providers in each NBFI sector typically have 80 percent market share.
  - PIC market: 100 percent market share among four remaining providers (Ilmarinen, Varma, Elo, Veritas).
- Geographic allocation of fund investments (end-December 2021):
  - Domestic Finland: Assets EUR 61,235 million; 34 percent of fund management assets.
  - Other EUR area: EUR 41,458 million; 23 percent.
  - North & South America: EUR 32,257 million; 18 percent.
  - Non-EUR (EU area): EUR 21,497 million; 12 percent.
  - Asia: EUR 7,588 million; 4 percent.
  - Europe (Non-EU): EUR 13,278 million; 7 percent.
  - Total: EUR 180 057 million; 100 percent.
  - Interpretation: 57 percent of assets within the Euro area; 76 percent invested in Europe when combining EU and non-EU Europe.
- Solvency ratios (end-2021):
  - Life insurers: close to 200 percent.
  - Nonlife insurers: close to 250 percent.
- FIN-FSA supervisory process:
  - Combines off‑site and on‑site supervision with a quarterly risk assessment ‘heat‑map’ combining quantitative inputs and a governance assessment weighted 40 percent.

### Liquidity, leverage, solvency supervision and stress testing (selected findings)
- Temporary fund suspensions in Finland during COVID‑19: 37 funds with total AUM EUR 3.5 billion (2 percent of industry AUM); suspensions 1–8 days.
- FIN-FSA stress tests on corporate bond funds: all passed redemption coverage ratio; in a simulated redemption shock two of eight funds could not make redemptions immediately but all could within a month.
- Leverage: five funds using leverage over 300 percent of assets (predominantly hedge funds, average size EUR 17 million); 25 AIFs with assets over EUR 300 million with gross leverage of 127 percent.
- Solvency testing for PICs uses a 97 percent one‑year probability standard; one‑year stress testing for long‑horizon institutions yields limited benefit unless liquidity/fire‑sale channels exist.

### Risks: Russia, cyber, and climate
- Russian invasion: first‑round effects limited for insurance; second‑round macro effects larger via inflation and interest rates.
- Cyber risk: heightened after the war in Ukraine and Finland’s NATO move; requires technical supervisory resources and sector preparedness.
- Climate change and sustainable finance: major long‑term risk; SFDR imposes significant costs and data challenges; FIN‑FSA flagged climate as an emerging risk and conducted thematic ORSA reviews.

### PIC solvency valuation approach and disconnect with long‑run actuarial modelling
- Solvency regime updates Technical Provisions annually by a Required Rate of Return rather than market‑consistent discounting; wage increases or inflation do not directly enter solvency liability calculation.
- Required Rate of Return formula: Required Rate of Return = 3 percent + f(Average PIC Solvency) + f(percent average Equity Return).
  - Base rate: 3 percent.
  - f(Average PIC Solvency): links to average solvency; since 2022 can reduce the Required Rate of Return if average solvency falls below 120 percent.
  - f(percent average Equity Return): links 20 percent of market changes (was 10 percent initially), with an upper limit of 1 percentage point and a lower limit of 20 percent of the technical provisions.
- Risk‑weighted capital: 18 risk categories, government decree sets assumed returns, risk weights and correlation matrix unchanged for past 5 years.

### PIC solvency data (Table 6 — Finland: Solvency Data on the Pension Insurance Companies, 2021)
- PIC Solvency capital (Billions of EUR): Total 41.1 / PIC 1 16.5 / PIC 2 16.9 / PIC 3 6.6 / PIC 4 1.1
- Required Solvency Capital (Billions of EUR): Total 22. 0 / PIC 1 8.7 / PIC 2 8.5 / PIC 3 4.2 / PIC 4 0.6
- Minimum capital requirement (0.33 of Required Solvency Capital): Total 7.3 / PIC 1 2.9 / PIC 2 2.8 / PIC 3 1.4 / PIC 4 0.2
- Technical provisions (increased annually by required rate of return): Total 114.8 / PIC 1 45,1 / PIC 2 42.9 / PIC 3 23.4 / PIC 4 3.4
- Risk-based solvency position or Solvency Limit (1/2): Total 1.9 / PIC 1 1.9 / PIC 2 2.0 / PIC 3 1.6 / PIC 4 1.8
- Solvency ratio PIC assets/Technical Provisions (in percent): Total 136 / PIC 1 137 / PIC 2 139 / PIC 3 128 / PIC 4 132

### Herding, cyclicality, long‑run context and international comparators
- Correlation and herding:
  - Correlation between major PICs in listed equity decisions surpasses 80 percent since 2018.
  - PIC allocation correlation with public pension funds greater than 90 percent since 2015.
- Cyclicality:
  - PICs historically showed procyclical selling in downturns up to 2017; public pension funds were more countercyclical.
  - Since 2018 differences have narrowed as regulatory pressures eased.
- Long‑run funding context:
  - Funding ratios end‑2017: private sector PICs 30.6 percent; central government 20.7 percent; local government 38.1 percent.
  - Private sector pension assets grew over 1997–2021 with average real growth over 4 percent.
  - ETK projection rates: 2.5 percent nominal until 2028 and then 3.5 percent thereafter.
- International example:
  - New Zealand Superannuation Fund target: 2.8 percent over Treasury Bills over a 20‑year period cited as an example of long‑run mandate and governance.

_Italic: Source — Excerpts and tables from the IMF staff report content unit 1finea2023006._

### EXECUTIVE SUMMARY __________________________________________________________________________ 4

### EXECUTIVE SUMMARY

### Overview
- This note evaluates non-bank financial institutions (NBFI) as a sector in Finland, with a special focus on the pension insurance companies (PIC).
- Analysis undertaken against the backdrop of the war in Ukraine, the energy crisis, rising central bank interest rates amid a sustained inflationary surge, and the aftermath of the COVID-19 pandemic.

### Size and composition of the NBFI sector (end-2021 figures cited)
- Statutory earnings-related pensions in the private sector: EUR 161 billion in assets (with the bulk in the PICs).
- Earnings-related plans for public sector workers and specialized regimes: EUR 94 billion in assets.
- Total insurance assets: EUR 89.6 billion (with EUR 73.0 billion in life and EUR 16.6 billion in nonlife insurance).
- Total fund management sector assets: EUR 180.0 billion.

### Recent performance and market events
- The NBFI sector faced fewer challenges during COVID-19 and the war in Ukraine than during the Global Financial Crisis (GFC), attributed to improved risk management, lower customer withdrawals, and increased demand for savings products during the pandemic.
- Strong market recovery after Q1 2020 and an exceptionally strong investment year in 2021 significantly boosted insurer and PIC capital positions.
- Total assets under management (AUM) in funds reached EUR 180 billion (end-2021).
- COVID-19 caused liquidity issues with suspensions in funds with total assets of EUR 3.5 billion.
- A small number of investment funds focused on Russia were suspended and subsequently closed; management companies used regulatory-permitted temporary suspensions.

### Supervisory interaction and regulatory burden
- Market participants value the relationship with the Finnish Financial Supervisory Authority (FIN-FSA), particularly during crises, but note that extra resources and expertise would be useful for the NBFI sector.
- Pace of new EU-driven regulation is creating significant costs and uncertainty for the sector; faster national regulations and more FIN-FSA support would aid firms.
- Recommendation that FIN-FSA publish a detailed annual supervisory plan to help industry prepare for regulatory changes and EU Common Supervisory Actions.

### Insurance sector solvency and vulnerabilities
- Insurance sector exhibits strong solvency overall, helped by:
  - High profitability in non-life (COVID-19 reduced claims).
  - Strong asset returns in 2021.
  - Rising interest rates in 2022 (liabilities declining even as asset markets fall).
- Warning: rising solvency from interest rate increases can create a misleading signal of sector strength.
- Insurers remain vulnerable to a sharp reversal in interest rates, further falls in equity markets, or a local real estate correction.
- High profits and relatively high charges from investment funds and unit-linked life insurance products indicate conduct-of-business risks exceed prudential risks.

### Macroprudential policy and disclosure
- FIN-FSA’s macroprudential strategy now includes the NBFI sector, but little is published by the Bank of Finland (BoF) or FIN-FSA on these issues.
- Insightful internal analysis exists and should be published proactively and developed further.
- Uninvestigated risk: potential domino effect triggered by the war in Ukraine via exposures across energy companies, banks, construction firms, and high-energy-demand firms.

### Sustainable Finance Disclosure Regulation (SFDR)
- Market requests additional forward guidance on SFDR and dialogue with ESMA and EU to ease implementation during stressed market conditions.
- NBFI sector and FIN-FSA committed to aligning finance with environmental considerations, but access to good quality data for investment signals is challenging; potential FIN-FSA regulatory forbearance could be useful short-term.

---

### Pension Insurance Companies (PICs): role and systemic importance
- PICs are part of the mandatory social security system and invest assets to partly fund the system.
- Impact of returns: an increase of 1 percent in real returns on their EUR 160 billion assets is equivalent to 2 percent of wages in contributions.
- Core purpose: long-run funding and stability of the social security system (contrasts with a role simply to provide extra pension savings).
- PICs are not subject to the EU Occupational Pension Directive (IORPII) or the EU Insurance Directive (Solvency II), giving the Government of Finland and FIN-FSA greater domestic regulatory freedom.

### Recent PIC performance and structural features
- PICs had particularly strong average returns in 2021: +16 percent.
- PIC assets fell in the first half of 2022: -6 percent (not considered a stability issue).
- PIC model does not have individual customers who can sell assets; employer borrowing against contributions should be limited further or removed.
- Transfers by employers to a new provider affect only new contributions, not the existing stock.
- PICs operate in an open mandatory pension system with close to 25 percent of wages paid each month and a long-term mission to generate returns to offset demographic cost pressures.

### Investment strategy, past behavior, and comparators
- Over the last 20 years, PICs have diversified away from Finland into illiquid assets (real estate, private equity, higher-quality hedge funds), consistent with long-term liabilities.
- Investment performance is lower than regional comparators and lower between 1998–2021 (particularly 1998–2017) than the local government fund which invested countercyclically without pressure from short-term solvency rules.
- FSAP analysis shows history of procyclical and herding behavior in PIC portfolios driven by solvency regulations:
  - Major PICs acquired or sold listed equity in a highly correlated manner; correlation between them now surpasses 80 percent.
  - PIC investment allocation became more similar to public pension funds after investment restrictions were loosened (2014 and 2017), with greater than 90 percent correlation since 2015.
  - Historically (1999–2017) PICs often pro-cyclically sold equities in response to negative shocks, whereas public pension funds invested countercyclically.

### Regulatory and supervisory implications for PICs
- 2017 solvency reforms appear to have reduced procyclicality but regulations remain too focused on the short-term to the detriment of long-run performance.
- Reforms should focus on enhancing the long-term purpose of PICs to generate returns.
- Liquidity risks are low, but a liquidity regulation should be developed so that PICs have sufficient buffers for extreme events.
- PICs are jointly liable for all their pension payments; authorities should run crisis simulation exercises of a large PIC failure covering policy response, market impact, funding response, and operational implications, drawing on resolution authority (RVV) work for insurance companies.
- FIN-FSA has limited resources for PIC supervision—regular on-site and off-site supervision of governance, investment, and operations is needed given PIC size.
- Rebalancing FIN-FSA resources away from low-risk issues (registrations, detailed technical advice for small non-PIC pension funds) would free resources for higher-risk supervision.
- FIN-FSA resources should have enabled deeper supervision of a PIC with governance issues rather than significant escalation only after solvency limits were triggered.

### Market conduct and costs
- Take a more proactive role on total costs given significant fee levels in the fund sector, in unit-linked insurance, and very large nonlife insurance profits.

---

### Key quantitative signals and metrics (as stated)
- PIC assets: EUR 160 billion (used for the 1 percent real return sensitivity).
- Impact of 1 percent increase in real returns on EUR 160 billion assets = 2 percent of wages in contributions.
- PIC average returns in 2021: +16 percent.
- PIC asset decline in H1 2022: -6 percent.
- NBFI fund suspensions during COVID-19: EUR 3.5 billion.
- Sector asset totals (end-2021):
  - Private statutory earnings-related pensions: EUR 161 billion.
  - Public sector and specialized regimes: EUR 94 billion.
  - Insurance total: EUR 89.6 billion (life: EUR 73.0 billion; nonlife: EUR 16.6 billion).
  - Fund management sector: EUR 180.0 billion.
- PIC correlation in listed equity decisions: now surpasses 80 percent.
- PIC investment allocation correlation with public pension funds: greater than 90 percent since 2015.
- Share of wages paid monthly into the open mandatory system: close to 25 percent.

---

### Recommendations (Table 1: Finland: Recommendations on Non-Bank Financial Intermediation)
- Recommendation 1: Amend PIC solvency regulations to remove remaining procyclical effects and develop new short-term liquidity rules. Agencies: MoSAH; FIN-FSA. Timing: NT.
- Recommendation 2: Publish an annual supervisory plan for the NBFI sector to aid planning and regulatory certainty for the industry. Agency: FIN-FSA. Timing: I.
- Recommendation 3: Enhance the public disclosure of analysis and assessment of macroprudential risks in the NBFI sector. Agencies: BoF; FIN-FSA. Timing: I.
- Recommendation 4: Reduce resources devoted to low-risk issues including detailed technical advice and registrations for non-PIC pension funds and pension foundations to free resources for higher risk areas. Agency: FIN-FSA. Timing: I.
- Recommendation 5: Continued forward guidance is required on the timing and specific actions in relation to the EU SFDR along with dialogue with ESMA and at EU level to ease the implementation during the current stressed market conditions. Agency: FIN-FSA. Timing: I.
- Recommendation 6: Consult on an increase in fees to enhance resources to supervise the NBFI sector, which appear to be too low. Agencies: MoF; FIN-FSA. Timing: NT.
- Recommendation 8: Enhance market intelligence in relation to NBFI trading (including on a daily basis) to better understand and monitor crisis experiences to augment the successful supervisory dialogue with regulated entities during periods of stress. Agencies: BoF; NBFI. Timing: NT.
- Recommendation 9: Take a more proactive role on total costs given the significant fee levels in the fund sector, in unit-linked insurance and given very large nonlife insurance profits. Agency: FIN-FSA. Timing: NT.
- Recommendation 10: Conduct a crisis simulation for the orderly resolution of a major PIC, involving FIN-FSA, the Ministry of Social Affairs and Health (MoSAH), the Ministry of Finance (MoF), and BoF, and drawing on the expertise of the RVV and ensure any necessary legislative and regulatory changes required are made. Agencies: FIN-FSA; MoSAH; ETK; RVV. Timing: MT.
- Recommendation 11: The Finnish Centre for Pensions (ETK) should conduct a cyber risk crisis simulation with the PICs, KEVA, and the National Pension Administrator (KELA). Agencies: ETK; PICs; KEVA. Timing: NT.

Note: Timing codes—I = Immediate (within one year); NT = Near Term (within 1 to 3 years); MT = Medium Term (within 3 to 5 years).

*Source: EXECUTIVE SUMMARY, 1finea2023006*

### 4.      The analysis of life and nonlife insurance and fund management sectors reviews

### 4.      The analysis of life and nonlife insurance and fund management sectors reviews

### Overview and key themes
- Reviews common and specific risks in an EU regulation–dominated environment, including:
  - recent experience on liquidity and the need for fund suspensions;
  - consumer behavior compared to previous crises;
  - impact of increased regulatory and consumer demands for sustainability reporting;
  - solvency position of the insurance sector;
  - cross-cutting risks: cyber security and environment, social and governance (ESG) issues.

### Size and composition of the NBFI sector (end-2021)
- Statutory earnings related pension for private sector workers: EUR 161 billion (bulk in PICs).
- Earnings-related plans for public sector worker plans and specialized regimes: EUR 94 billion.
- Total insurance assets: EUR 89.6 billion
  - Life: EUR 73.0 billion
  - Nonlife: EUR 16.6 billion
- Total fund management sector assets: EUR 180.0 billion

- Table 2 (selected figures, end-2021):
  - Fund Management: 180 (Euro, in billions); GDP Share: 72 (in percent)
  - Life insurance: 73.0; GDP Share: 29
  - Nonlife insurance: 16.6; GDP Share: 7
  - Pension Insurance Companies PICs*: 161; GDP Share: 64
  - Public Sector and specialized earnings-related pensions: 94; GDP Share: 37
  - Banking sector (consolidated): 870.4; GDP Share: 346
  - Stock market capitalization: 346; GDP Share: 138
- Note: *Earnings related pensions in the private sector include PICs as well as a small number of small Pension Fund and Foundations.

### Geographic allocation of fund investments (end-December 2021)
- Overall: 34 percent of fund management assets invested in Finland; 23 percent in other Euro area countries; 12 percent in the non-EUR (EU area); 7 percent in non-EU Europe; 18 percent in North & South America.
- Table 3 (selected figures, end-December 2021):
  - Domestic Finland: Assets (in millions of EUR) 61,235; Assets (as percent GDP) 34
  - Other EUR area: 41,458; 23
  - North & South America: 32,257; 18
  - Non-EUR (EU area): 21,497; 12
  - Asia: 7,588; 4
  - Europe (Non-EU): 13,278; 7
  - Total: 180 057; 100
- Interpretation: 57 percent of assets within the Euro area (34 + 23); 76 percent invested in Europe when combining EU and non-EU Europe (34 + 23 + 12 + 7).

### Market structure and concentration
- Top four providers in each NBFI sector typically have 80 percent market share.
- PIC market: 100 percent market share among four remaining providers.
- PICs dominated by mutuals and public sector not-for-profit institutions.
- Insurance: mixture of mutual and for-profit corporate providers with sometimes different pricing strategies.
- At end-2021 there were 47 Finnish insurers licensed by FIN-FSA:
  - 9 life insurers
  - 34 nonlife insurers
  - 4 PICs
  - 19 branches operated in Finland by foreign insurers
- The 4 PICs are Ilmarinen, Varma, Elo, and Veritas; two are among the top 25 largest pension funds in Europe.

### Investment allocations and trends (2013–22)
- Life insurers:
  - Broadly 65–70 percent of assets in fixed income securities.
  - Around 20 percent in equity.
  - Around 8 percent in real estate.
- Nonlife insurers:
  - Fixed income allocation fell from 70 percent in 2013 to around 55 percent by 2017, then broadly stable.
  - Equity allocation increased to up to 30 percent.
  - Real-estate allocation risen to close to 10 percent.
- PICs and smaller company/industry pension funds (2013 → 2022):
  - Fixed income: around 40 percent in 2013 → around 30 percent by 2022.
  - Equity: 35 percent → 45 percent.
  - Real estate: relatively stable at 10 percent.
  - ‘Other’ category (mainly hedge funds): final 10 percent.

### Solvency, profitability, and conduct issues
- Solvency in all parts of the insurance sector is strong, particularly after high investment returns in 2021.
- Life insurance solvency strengthened slightly in the first half of 2022 as rising interest rates offset poor investment returns.
- Solvency ratios (end-2021):
  - Life insurers: close to 200 percent.
  - Nonlife insurers: close to 250 percent.
- Rising interest rates and volatility adjustments to interest rates (permitted under Solvency II) have helped keep solvency levels at historic highs despite market challenges in early 2022.
- Concerns:
  - High solvency ratios could enable significant dividend extraction by ultimate owners, potentially leaving companies vulnerable to rapid reversals in interest rates.
  - Nonlife sector’s historically high solvency partly reflects very strong profitability during the COVID-19 pandemic due to reduced claims; this raises potential conduct and pricing concerns despite reduced prudential and stability risks.
- EIOPA analysis: solvency in Finland is in the top quartile in Europe with a much smaller distribution of solvency ratios across the market than in nearly all other countries.

### Regulatory and supervisory architecture
- FIN-FSA is an integrated regulator covering banks, insurance and pension companies, investment firms, fund management companies, and the Helsinki Stock Exchange.
- Insurance and pensions supervision combined in one division within the Insurance department; cross-cutting teams for Investments in insurance and pensions within the Life and Nonlife division.
- Internal cross-cutting divisions: Investments, Legal, and ‘Digitalization and Analysis’.
- Within Insurance Department: units for Life and Nonlife Insurance; Employee Pension Institutions; Conduct of Business.
- Supervisory process:
  - Combines off-site and on-site supervision.
  - Quarterly risk assessment process creates a ‘heat-map’ for each sector informing the supervisory plan.
  - Quarterly heat map uses quantitative and qualitative inputs to derive entity-specific risk ratings.
    - Quantitative elements include solvency capital relative to the solvency limit, assets as a percentage of technical provisions, stress test results, and solvency limit as a share of assets.
    - Governance assessment carries a 40 percent weighting based on expert supervisory judgement.
  - Quantitative and qualitative ratings combined to assign risk class and overall supervisory rating.

### Legal and directive context for insurance and pensions
- Life and nonlife companies regulated by Insurance Company Act, under the Ministry of Social Affairs and Health (MoSAH) rather than the Ministry of Finance.
- Solvency II is a ‘maximum harmonization’ directive; Finnish Insurance Company Act heavily dominated by Solvency II provisions.
- Occupational pensions EU directive ‘IORP II’ is ‘minimum harmonizing’, allowing national jurisdictions additional provisions.
- Statutory earnings-related pensions (PICs) are legally part of the social security system; therefore:
  - Solvency II and IORPII do not apply to statutory earnings-related pensions.
  - PICs are covered by some Solvency II–inspired Insurance Company Act provisions, the Pension Insurance Act, and the Act on Solvency Limit and Investments.
- Nonlife sector provides elements of Social Security (mandatory Workers’ Compensation, mandatory motor insurance) and pays out annuities in severe accidents, delivering life-insurance-type business.
- Life insurance sector has effectively stopped providing guaranteed investment products in preference for unit-linked or asset-related investment products.
- Preparation of laws and issuance of provisions and decisions on PICs and life and nonlife insurance rests with MoSAH.
- Supervision of insurance and PIC sectors undertaken by Insurance Supervision Department in FIN-FSA:
  - Life and nonlife insurers supervised by Life and Nonlife Insurance and Supervision of Investment Activities Division.
  - PICs supervised by Employee Pension Institutions Division.

### Regulation and supervision of investment funds
- Supervision by FIN-FSA Capital Markets team; responsibilities include fund management companies, alternative investment fund managers, investment-based crowdfunding intermediaries, Stock exchange, and Finnish Central Securities Depository (joint authority with Ministry of Finance).
- Regulation closely follows EU directives:
  - UCITS; AIFMD; MIFID II; PRIIPS; SFDR (Sustainable Finance Disclosure Requirements Directive) significantly impacting fund and asset management sector.
- Market structure:
  - UCITS fund sector dominated by a few large players; two institutions owning 64 percent of AUM.
  - In the smaller (AIF) sector the top two institutions constitute 36 percent of total assets.
- FIN-FSA practice:
  - Aims to follow EU Directives and ESMA guidance closely, mirroring detailed aspects such as FAQs.
  - Delays in ESMA or FIN-FSA guidance can constrain firms’ time to develop compliant processes and systems.
  - FIN-FSA uses ESMA risk heat maps as input to FIN-FSA heat maps and annual supervisory plans.
  - Internal FIN-FSA supervisory plans are detailed but often not published in any detail, which can challenge industry planning during multiple concurrent EU regulatory changes.
- Common business model: thin corporate entity with UCITS or AIFMD registration, asset management outsourced to portfolio managers elsewhere in the group; distribution often focuses on cross-sales with other group parts.

### Macroprudential policy and NBFI risks
- FIN-FSA updated macroprudential strategy published on June 27, 2022.
  - Strategy sets primary goal of macroprudential policy and four intermediate objectives, five operational policy objectives, and a range of instruments.
  - Intermediate objective three: improving risk resilience with a focus outside traditional credit institutions.
  - Operational objective three: need (as allowed by legislation) to impose macroprudential requirements on institutions outside traditional credit institutions.
  - Identified potential instruments:
    - leverage limits for AIFMs;
    - instruments based on Solvency II and “other instruments applicable to insurance institutions”;
    - “Exceptional measures targeted at pension providers” (including regulatory measures).
  - In absence of binding measures, FIN-FSA issues recommendations and warnings to financial market participants where appropriate.
- Public discussion and transparency:
  - Potential impact of NBFI on financial stability and related actions have had very limited public discussion in twice-yearly stability review and related proposed measures.
  - Significant internal analysis, discussion, and supervisory thematic reviews (e.g., liquidity management in NBFI) are underway.
  - FIN-FSA plans to extend and deepen analysis for insurance and pensions sectors.

*Source: 1finea2023006 - 4.      The analysis of life and nonlife insurance and fund management sectors reviews*

### 32.      Going forward, the FIN-FSA should ensure that internal analysis and evaluations

### 1finea2023006 - 32.      Going forward, the FIN-FSA should ensure that internal analysis and evaluations

### Publication of internal analysis and macroprudential process
- FIN-FSA should ensure that internal analysis and evaluations are published; approach should be tailored to the Finnish context and could build on the quarterly ECB Financial Stability Review (Section 4 always on the NBFI sector).
- As part of the process to use macroprudential instruments, FIN-FSA must seek the comments of the MoSAH, the Bank of Finland and the Ministry of Finance; this is useful for PICs given their role in the broader pension system and allows MoSAH to provide specialist pension-related input.
- The June 2022 macroprudential policy strategy memorandum notes that “Macroprudential stability assessments should also take into account new types of global risks, such as cyber and climate risks.” These are both relevant to the NBFI sector, with climate risks particularly pertinent for very long horizon investors such as the PICs and insurance companies.

### Regulation and Supervision — Liquidity
- The biggest issue for the fund and asset management sector during the COVID-19 pandemic and since the start of the war in Ukraine was liquidity; issues were at times present though not severe or badly managed.
- Practices differed across fund companies regarding continuing to price daily-priced investment funds and keep them open; some providers avoided suspensions, others used suspensions.
- Regulatory allowance: suspension permitted for a ‘temporary period’ interpreted in Finland to mean up to 14 days; funds with exposures to Russia experienced non-temporary suspensions.
- Evolution in practice: after 9/11 and the Global Financial Crisis FIN-FSA led suspension decisions; in recent crises funds can take the lead while informing FIN-FSA, speeding response and placing initial responsibility with funds.
- All interviewed funds implemented crisis management measures and valued FIN-FSA’s rapid aligned stance; consensus that system performed much more effectively than in the 2007–08 market crisis.
- Determinants for suspending trading included market data (trading volumes, bid-ask spreads) and subjective assessment of crisis gravity and orderliness of trading; regular contact with FIN-FSA supported suspension decisions.
- Empirical figures on suspensions:
  - Temporary suspensions occurred in 37 funds registered in Finland with a total AUM of EUR 3.5 billion or 2 percent of the industry AUM.
  - The suspensions varied between one to eight days.
- FIN-FSA participated in two Common Supervisory Actions by ESMA and ESRB on liquidity management in UCITS and non-UCITS; results published April 2021 covering all Finnish management companies with focus on high-yield (investment grade) corporate bond funds.
- Stress test outcomes:
  - In tests with corporate bond funds, all passed the redemption coverage ratio test based on the proportion of liquid assets.
  - In a simulated redemption shock, two of the eight funds would not have been able to make redemptions immediately, but all would have been able to do so within a month.
  - All sampled real estate funds met the stress tests.
- FIN-FSA conclusions and expectations:
  - Management companies should ascertain that fund rules allow adequate use of liquidity management tools where appropriate.
  - Before using liquidity management tools, management companies must ensure the quality and adequacy of processes, systems, personnel competence and resources.
  - Management companies should pay special attention to internal flow of information and clear reporting relationships so portfolio management can anticipate incoming cash flows as well as possible.

### Regulation and Supervision — Leverage
- 2016 FSAP noted relatively low leverage levels in larger investment funds; remains true in 2022.
- UCITS directive limits leverage to up to 10 percent of NAV; can only be temporary and not used for investment purposes.
- AIFM directive does not limit leverage, but FIN-FSA can impose case-by-case limits.
- National legislative limits exist on leverage in open-ended real estate funds (Real Estate Act).
- FIN-FSA reported at end-2021:
  - 5 funds using leverage on a very significant level—over 300 percent of assets; predominantly hedge funds with an average size of EUR 17 million.
  - 25 alternative investment funds with assets over EUR 300 million with gross leverage of 127 percent (where 100 percent is no-leverage).

### Regulation and Supervision — Solvency
- Recent significant increases in interest rates (likely to continue with inflationary pressure) have important implications for liabilities and assets.
- Up to 2022Q2, quarterly changes in Solvency Ratios for Life and nonlife insurers show interest rate impact on liabilities dominating any effect from falling valuations of bond investments; FIN-FSA is closely monitoring and publicly commenting.
- FIN-FSA expects less severe solvency risks for Life sector due to shift from guaranteed interest rate products to unit-linked products; guaranteed products are challenging in prolonged low-interest environments, whereas unit-linked products have much lower solvency requirements though deliverability of positive real returns after costs is a challenge.
- Shift in technical provisions:
  - Unit-linked share of insurance company technical provisions: 64 in 2016 and 77 in 2021 (Table 4).
  - Total premiums for unit-linked products in 2021 were higher, at 89 percent.
- Nonlife insurance sector: very high levels of profitability mean solvency risks are not high; FIN-FSA’s 2022 Q2 results for Nonlife Sector confirmed solvency at record levels.
- Structural note: nonlife sector delivers significant annuity business linked to statutory schemes (e.g., workers compensation); for some providers these account for a significant majority of required regulatory capital—long-standing Finnish feature.
- Policy focus recommendation: given strong solvency, FIN-FSA risk focus should shift toward conduct of business or value-for-money issues (not a stability issue per se), responding to increased attention from EIOPA and ESMA on cost and value issues.

### Other Risks and Vulnerabilities — Russia
- Russian invasion of Ukraine significant geopolitically for Finland but has not led to major impacts on insurance sector to date.
- First-round effects small due to largely domestic operations; second-round effects larger through global financial markets and through economy via rising inflation and interest rates.
- Impact on solvency ratios manageable so far due to high pre-crisis solvency levels and offsetting rising interest rates.
- Key area for risk assessment: potentially escalating restrictions on energy supply from Russia to Europe.
- For limited funds with direct exposure to Russia experience was rapid suspension followed by closure rather than temporary liquidity issues; Russia-specific fund suspensions temporarily affected some fund-of-funds; fund managers moved rapidly to close funds and effectively write-down assets in an orderly process.

### Other Risks and Vulnerabilities — Cyber Risk
- Cyber risk has become more important, with particular increase after the start of the war in Ukraine and Finland’s move to join NATO.
- Threats may be augmented by state actors in addition to criminal activity.
- Regulatory and insurance sector concerted action required.
- Concern over FIN-FSA resources to address supervisory risks is acute in cyber area where new and highly technical resources may be needed alongside communications and outreach.
- All interviewed organizations reported increased cyber preparedness, often in the context of major long-term IT upgrades; threats have not yet materialized in ways that can be independently tested.

### Other Risks and Vulnerabilities — Climate Change and Sustainable Finance
- Climate change and sustainable development represent perhaps the biggest long-term risk for investors in companies, countries and sectors negatively affected by climate change.
- Significant and increasing global activity (UN context/Sustainable Development Goals), regional and national activity; EIOPA consulted on guidance for including climate change in ORSA for life and nonlife insurers; ESMA set out priority actions to tackle greenwashing, promote transparency, build capacities of ESMA and national competent authorities, and monitor ESG and markets risk.
- Tackling climate change is a national government priority in Finland; flagged as an emerging risk by FIN-FSA which is focusing increasing attention.
- FIN-FSA conducted a thematic review on the quality of ORSAs and investment related risk in H1 2022 to assess how climate (and other risks) are tackled in ORSA.
- EU Sustainable Finance Disclosures Regulation (SFDR) requirements:
  - SFDR amends UCITS, AIFMD, Solvency II, IDD and MIFID II with common additional requirements.
  - A detailed technical standard on required disclosures developed by EU market regulators comes into force in January 2023.
- Market participants reported SFDR imposes significant costs and requires rapid decisions where data often not robust; FIN-FSA has released guidance but faces constraints from EU timetable beyond its control.
- PICs reported SFDR burden alongside multiple other regulatory requirements and impacts of COVID and the war in Ukraine.

### Pension sector risks — Views of the Pension Insurance Companies (Box 1)
- Financial sustainability:
  - Major PICs identify long-term financial viability of current Finnish pension arrangements as a key risk.
  - Built-in (indexation and longevity) adjustment mechanisms are not able to ensure pension contributions cover expenditures in the long run.
  - PICs see solutions in raising pension contributions and strengthening adjustment mechanisms, potentially with automatic features tying contribution levels to indicators affecting financial balance; downside is potential transfer of risks to individual pensioners.
  - Publication of new Finnish Centre for Pension’s (ETK) long-run projection in October 2022 is timely (noted by PICs).
- Long-term investment strategy:
  - Market volatility has encouraged long-term thinking; solvency regulations can lead to procyclical investment behavior (forced selling when equity prices fall).
  - Calls for reform in investment operations and solvency regulations persist despite recent mitigations to procyclical impacts.
- Economic outlook and war impact:
  - Direct exposure of PIC portfolios to Russia is limited, but the war has increased risks to economic outlook and solvency under stress scenarios.
  - Increased uncertainty about investment returns and achievement of investment targets; tightening financial conditions and fiscal policy matter to PICs facing higher interest rates and lower liquidity.
- Risks to solvency:
  - Solvency affected by investment activities, insurance business surplus and expense loading; investment operations pose highest risk presently.
  - PICs have increased shares of riskier investments (real estate, hedge funds) over the past decade; major PICs have limited government bond exposure for liquidity reasons and increased equity share.
- Other strategic risks:
  - Finnish pension system is earnings-based and dependent on economic growth, robust employment and favorable demographics.
  - Mismatches between labor supply and demand, robust post-pandemic growth insufficient to bridge sustainability gap; household indebtedness and population aging will exert pressures on public finances.

*Source: Excerpt from 1finea2023006 (FINLAND) — IMF country report content provided.*

### 49.      Finland has a multi-pillar pension system. It has a residency-based national pension,

### Finland has a multi-pillar pension system. It has a residency-based national pension,

### Overview
- Finland’s pension system is multi-pillar: a residency-based national pension, a guaranteed pension for people with no other pension income, a large housing allowance, and earnings-related ‘statutory’ pensions.
- Earnings-related pensions become increasingly important as income rises and other pension forms are withdrawn.
- There are active debates on the overall balance and long-term sustainability of the Finnish pension system; significant projections and analyses have been published (including new projections in October 2022).

### System structure and benefits
- The earnings-related pensions are Defined Benefit (DB) style: accrual depends on years of service and wages.
- Past wage levels are increased by an index composed of 80 percent of wages and 20 percent of prices to calculate the final pension.
- Once the pension is paid, it increases each year by an index that is 20 percent wages and 80 percent prices.
- Workers accrue pensions at 1.5 percent a year — meaning that a 40-year career would give 60 percent of salary.

### Contributions, coverage, and provider choice
- Private sector contributions: 24.4 percent of salary, split two-thirds for employers and one-third for employees.
- Local government worker contributions: 28.4 percent.
- The system is mandatory with near universal coverage.
- Employers and unions negotiate contribution levels annually; contribution levels depend on PIC investment performance.
- Employers choose a PIC provider on behalf of workers; members do not choose providers and cannot transfer assets out of the system except in limited pension-transfer cases.

### Pension Insurance Companies (PICs) and assets
- The PICs contain most private sector earnings-related pension assets; local government fund and central government buffer fund dominate the remainder.
- There are currently four PICs: Elo, Ilmarinen, Varma, and Veritas.
- AUM (end-2021) and relative size (end-2020):
  - Local Government Fund: 66.8 (Rank in European Pensions: 21)
  - PIC 1: 60.8 (Rank: 23)
  - PIC 2: 59.0 (Rank: 25)
  - PIC 3: 29.4 (Rank: 61)
  - Central Government Fund: 23.6 (Rank: 82)
  - PIC 4: 4.4 (Rank: 392)
  - Total (incl. related smaller funds): 254.9; o/w PICs and public pension funds 96 percent of total
- The three largest PICs are mutuals; the smallest is a limited company. Not-for-profit entities control nearly all of Finland’s EUR 250 bn pension industry.
- PICs may only carry out PIC business and cannot offer other products such as general insurance or asset management.

### Market structure and consolidation
- The PIC market has consolidated over time (examples: Alandia merged into Veritas in 2019; Etera merged into Ilmarinen).
- PICs compete for employer clients via rebates of solvency capital (up to 1 percent return to employers), lower operating costs, reputation, and associated agreements with other financial providers.
- The market is in practice closed to foreign providers given unique requirements such as joint liability.

### Asset allocation and returns
- Asset allocations have shifted toward equity (including private equity), real estate, and hedge funds, with a fall in fixed income between 2016 and Q1 2022.
- Allocation to illiquid investments has grown substantially; increased allocations have supported returns but increased volatility (partly dampened by quarterly pricing on illiquid assets).
- The regulatory loosening over time permitted greater allocation to private equity and reduced solvency capital required to back private equity since 2017.

### Liquidity features and risks
- The system is ‘open’ (contributors continually join), producing high cash inflows and generally very low liquidity risk relative to many pension funds.
- Two difficult-to-model exceptions to low liquidity risk:
  - Employers’ statutory right to borrow from PICs based on the value of their past contributions (was used extensively during the global financial crisis).
    - A PIC may restrict borrowing to 10 percent of the employer’s funds in the relevant PIC in a 12-month period or for liquidity reasons.
    - The text recommends that this right should be removed or more significantly constrained given unpredictability and potential scale.
  - Temporary government reductions in employer contributions during economic stress (example: during the COVID-19 pandemic the Government temporarily reduced employer contributions by 2.6 percentage points).
    - These temporary reductions must legally be made up; there will be a small increase in contributions for the next 4-5 years to make up the difference.
    - Such symmetric temporary reductions can be an effective macroeconomic tool but require close dialogue with pension providers to avoid liquidity issues.

### Solvency rules, regulation, and supervisory issues
- PICs are jointly liable to pay pensions promised under the Employees’ Pension Act; if a PIC ceases to operate, its share of pension liabilities transfers to other providers along with assets.
- There is limited clarity on the process and arrangements for failure of a major PIC; the report suggests this should be investigated via a crisis simulation.
- Legislative and regulatory framework:
  - Governed by acts from MoSAH (Act on Earnings-Related Pensions Insurance Companies), Insurance Act provisions, Act on Solvency Limits and Investment Diversification, and regulations/guidelines from FIN-FSA.
  - PICs are not covered under EU Insurance or Pension directives; in return they can only provide earnings-related pensions as part of the mandatory Social Security system.
- Solvency rules (two ongoing tests):
  - Solvency ratio = total pension assets divided by technical provisions; formally must be above 100 percent. In practice current average is around 130 percent.
  - Solvency position = ratio of solvency capital to risk-weighted required capital; typically around 1.5 to 2 in normal times.
    - If a PIC falls below 1 it must inform the FIN-FSA of a plan to restore the ratio above 1, typically within a year.
    - Formally, the minimum solvency position is 0.3 at which point there must be an urgent plan for restoration within 3 months; in practice the 1.0 level is treated as binding by the market.
- The report highlights a disconnect between short-term solvency regulations (including the detailed rate of return calculation that increases liabilities for PICs each year) and long-term projections on the costs of financing Finnish pensions.
  - Long-term projections are driven by PIC investment returns and actuarial factors (mortality, dependency ratios, employment rates, effective retirement ages, growth in salaries and inflation).
  - Recommendation: strengthen the system by having the long-run funding framework help drive short-run supervisory actions by FIN-FSA.

### Key analytical points and policy implications
- The open, long-duration nature of the PIC liabilities supports a long-term investment horizon and the ability to invest in illiquid assets to harvest an illiquidity premium, provided asset and contribution flows are sufficient to meet payments.
- If pension payments begin to exceed contributions plus investment income and assets are drawn down, the appropriate investment horizon shortens and PICs would need to be treated more like closed DB occupational plans or annuity portfolios.
- Important areas to monitor and address:
  - Aligning solvency and liquidity regulations with the central purpose and long-term nature of the funds.
  - Constraining or removing employers’ right to borrow from PICs.
  - Clarifying failure-resolution processes for major PICs, including crisis simulation exercises.
  - Ensuring close dialogue between the government and pension providers when using temporary contribution reductions as macroeconomic policy.
  - Monitoring increased allocations to illiquid assets and the potential for liquidity stress in systemic downturns.

*Italic: Source — Excerpt from IMF staff discussion on the Finnish pension system (content unit: 1finea2023006 - 49).*

### 68.      The approach in the solvency regulations to valuing liabilities for the PICs is very

### 1finea2023006 - 68.      The approach in the solvency regulations to valuing liabilities for the PICs is very

### Solvency valuation approach and disconnect with long-run actuarial modelling
- The approach in the solvency regulations to valuing liabilities for the PICs is very different to that for insurers under Solvency II and does not have any real link with the approach used in the long-run actuarial modelling of the health of the Finnish pension system.
- To calculate key regulatory ratios the solvency regime requires calculation of Technical Provision and Risk Weighted Capital Requirements.
- The solvency regime updates Technical Provisions each year by a Required Rate of Return rather than by a market-consistent discounting of future liabilities; wage increases or inflation do not directly enter the solvency liability calculation.
- The formulaic annual change in Technical Provisions can lead to rapid changes in solvency capital and solvency ratios that are largely disconnected from:
  - the PIC’s ability to take investment risk;
  - recovery in equity markets;
  - actual changes in the costs of the DB pension system (driven by mortality, salary changes and inflation, benefit formulas, employment rates, effective retirement ages, dependency ratios).

### Key statistics on PIC solvency at end-2021 (values in Billions of EUR and percents)
- Table 6 — Finland: Solvency Data on the Pension Insurance Companies, 2021 (All numeric values preserved exactly as shown)
  - Total PIC / PIC 1 / PIC 2 / PIC 3 / PIC 4
  - 1. PIC Solvency capital: 41.1 / 16.5 / 16.9 / 6.6 / 1.1
  - 2. Required Solvency Capital: 22. 0 / 8.7 / 8.5 / 4.2 / 0.6
  - 3. Minimum capital requirement (0.33 of Required Solvency Capital): 7.3 / 2.9 / 2.8 / 1.4 / 0.2
  - 4. Technical provisions (increased annually by required rate of return): 114.8 / 45,1 / 42.9 / 23.4 / 3.4
  - 5. Risk-based solvency position or Solvency Limit (1/2): 1.9 / 1.9 / 2.0 / 1.6 / 1.8
  - 6. Solvency ratio PIC assets/Technical Provisions (in percent): 136 / 137 / 139 / 128 / 132
- Source: FIN-FSA

### Required Rate of Return: formula, components, and incentives
- Required Rate of Return formula:
  - Required Rate of Return = 3 percent + f(Average PIC Solvency) + f(percent average Equity Return).
- Components and features:
  - Base rate: 3 percent — longstanding, does not change with market interest rates, not market-consistent, unrelated to ETK assumptions used for long-term projections.
  - f(Average PIC Solvency): designed to link an individual PIC to average solvency given joint liability; until 2022 had a lower bound of 0 percent; since 2022 if average solvency of PICs falls below 120 percent this term can reduce the Required Rate of Return (and hence the annual increase in Technical Provisions).
    - This term historically tended to increase the Required Rate of Return and contributed to herding behavior among PICs.
  - f(percent average Equity Return): links changes in the equity market to the Required Rate of Return.
    - Initially included 10 percent of market changes; now includes 20 percent.
    - It may be positive or negative.
    - Upper limit of 1 percentage point and a lower limit of 20 percent of the technical provisions.
    - Designed as a buffer against equity fluctuations and to reduce short-run annual pressure to react to market changes.

### Risk-weighted capital calculation: complexity and static parameters
- Risk-weighted capital calculation is substantially more complex than the Required Rate of Return and increases system complexity.
- Features:
  - 18 risk categories included, covering main asset classes.
  - For each asset class there is a required rate of return and a risk weighting formula.
  - A correlation matrix is used to calculate diversification benefits.
  - Assumed rates of return, risk weights, and the correlation matrix are set out in a Government Decree and have been unchanged for the past 5 years.
- Implications:
  - The lack of adjustment over time reduces the link between the risk-weighted capital numbers and current market behavior.
  - The computation may not reliably highlight real short-term risk or mitigation via diversification.
  - Even if static relations held, the approach does not directly affect a PIC’s ability to generate long-term returns.
- Example: The correlation matrix used in calculation is provided by the FIN-FSA (Figure 5 in source).

### Stress testing, supervisory practice, and governance interventions
- FIN-FSA conducts solvency stress tests focusing on how large changes in key inputs would force PICs to breach regulatory thresholds.
- Stress-test design and observations:
  - Tests consider a 97 percent probability that PIC solvency capital will be sufficient over a one-year horizon (linked to insurance-based 99.5 percent one-year risk standard).
  - Required fall in equity to trigger breaches varies over time with solvency levels and market conditions.
    - Larger falls in equity prices (over 40 percent) were needed at end-2019 or in Q2 2020 to force breaches than in Q1 2020, where a fall 10 percentages point lower would trigger limits overall.
  - Applying a 97 percent one-year stress test to institutions with a long-run mandate does not appear to deliver much benefit for long-run funding risks unless one-year shocks precipitate liquidity issues and fire-sale dynamics.
- Supervisory escalation example:
  - A PIC subject to special supervision breached the solvency limit for one day; scrutiny escalated rapidly and concluded the breach was a consequence of governance failures.
  - FIN-FSA appointed an Ombudsman in December 2020; intervention ended end-June 2022, but governance-driven reorganization and redundancies continued.
  - The episode serves as a cautionary tale of the market risk of breaching short-term solvency rules even with post-2017 regulatory flexibility.
- Question for FIN-FSA: whether intervention strength and speed would have occurred without the solvency-limit breach, given off-site and on-site supervision and resource constraints.

### PIC investment strategies, allocations, and performance comparisons
- Broad allocation changes 2012–22:
  - PICs significantly increased equity allocation (including private equity) so by 2022 their allocation was much closer to public sector institutions (which are not subject to solvency rules).
  - Both PICs and public pension funds increased allocations to ‘other equity’ (driven by private equity); PIC private equity allocation nearly doubled after 2017 regulatory changes.
  - PICs consistently had higher allocations to hedge funds and real estate than public funds.
  - Both PICs and public funds reduced fixed income allocations; money market funds and cash-like investments allocation remains relatively high.
- Rates of return comparisons:
  - Over 1997–2021: public sector funds returned 6.6 percent vs. PICs 6.2 percent.
  - Between 2017–21: PICs returned 7.9 percent vs. public funds 7.6 percent.
  - In 2021: PICs 16.2 percent vs. public funds 15.2 percent.
  - Over a 25-year horizon a 0.4 percentage point annual difference implies 9.4 percent cumulative difference; applied to EUR 260 billion in total assets this would be EUR 24.4 billion.
- Home bias and geographic allocation:
  - ETK (2015) found PICs had relatively higher allocations to Finland contributing to underperformance vs. regional/global comparators.
  - Since 2011 the share of PIC assets in Finland fell from near 40 to 25 percent from 2011 to 2022; growth in ‘Rest of the World’ outside the euro area largely reflects allocations to non-euro EU and non-EU Europe.
  - ETK (2022) analysis using 2021 data shows relative performance of PICs improved compared to 2014, driven by increased equity (including private equity) and greater geographical diversification.
- Cyclicality and correlation in equity investment:
  - Listed equity shares are more stable for public pension funds and constitute a bigger share of their portfolios than for PICs.
  - Quarterly rates of return for listed equities are similar across funds, but PICs exhibited more volatile behavior and sold equities during large negative shocks (e.g., 2011 and 2020), contrasting with slower reductions by public pension funds.

*Source: FIN-FSA; material reproduced from the IMF staff report content provided.*

### 86.      The analysis reveals a herding behavior in the portfolio allocation of the pension

### 1finea2023006 - 86.      The analysis reveals a herding behavior in the portfolio allocation of the pension

### Herding and correlation in equity allocation
- Major PICs have acquired or sold listed equity in a highly correlated manner.
- Correlation between the investment behavior of major PICs has been high and grown over time, surpassing 80 percent since 2018.
- As investment restrictions on the PICs have been loosened (in 2014 and 2017) while retaining the 1-year solvency focus, the PIC investment allocation has become more like that of pension funds with greater than 90 percent correlation in the recent years.
- Public pension funds’ investment strategy is correlated at levels close to and above 90 percent with all pension insurance companies.
- Listed equities are daily priced and hence most sensitive to valuation changes; private equity with quarterly pricing will not show the same volatility in solvency-rule calculations and is less subject to pressures for short-term sales.

### Cyclicality of investment behavior
- Investment patterns of all pension funds have been countercyclical during the entire period, however, less so for PICs.
- A procyclical (countercyclical) investment behavior is defined: more stocks acquired (sold) during boom periods and sold (acquired) during bust periods.
- The state and government local funds have been investing more countercyclically compared with the PICs.
- The difference between PICs and public pension funds has not been significant since 2018 when regulatory pressures have been less on the PICs.
- Over the period up to 2017, major PICs show patterns of selling stocks during stock market downturns while public pension funds invest more stably during periods of distress.
- During downturns in equity markets, two of the three major PICs exhibited a-cyclical investment patterns with cyclicality estimated close to zero, while public pension funds could continue to invest countercyclically.
- Short-term market pricing of listed equities amplifies cyclicality pressures under solvency rules, potentially inducing short-term sales.

### Long-run defined benefit (DB) liabilities and funding context
- The fundamental purpose of the PICs is to generate assets that partly fund DB pension liabilities for private sector employees.
- For local government employees there is a broadly equivalent institution, and a buffer fund exists for central government pension liabilities; these are substantial at EUR 67 billion and EUR 24 billion respectively.
- Long-term pension liabilities are funded by a combination of current contributions (pay as you go, PAYG) plus funding from the earnings-related funds.
- The relative funding ratio for private sector employees covered by the PICs at the end of 2017 was 30.6 percent.
- For central government workers the funding ratio was 20.7 percent and for local government workers 38.1 percent.
- Understanding PIC performance requires focus on long-term evolution of the funding ratio as well as short-term solvency ratios.

### Historical asset growth and benchmarks
- Private sector pension assets (overwhelmingly PIC assets) grew between 1997 and 2021 with significant volatility during periods of market stress such as 2007–08, 2018 and 2020.
- PIC assets have grown by over 4 percent real on average over the 24 years since 1997.
- ETK’s projections used a rate of 2.5 percent nominal until 2028 and then 3.5 percent thereafter.
- The fact that PIC asset growth has exceeded these ETK figures contributed to increases in (partial) funding of pension liabilities and informed the new ETK October 2022 projections.

### International example: New Zealand Superannuation Fund (NZ Super)
- NZ Super has a legal requirement to “maximize returns without undue risk to the Fund as a whole,” with a specific target to deliver 2.8 percent over Treasury Bills over a 20-year period.
- The Fund adopted a long-run asset allocation with relatively high equity and substantial overseas allocation to meet the long-run target and diversify risks.
- During the 2007–08 Global Financial Crisis the Fund experienced significant downturns early in its life but maintained strategy and did not sell assets, subsequently outperforming the long-term target.
- Key elements of NZ Super’s success: a robust, stress-tested, long-run strategy; effective implementation; and clear and public benchmarking on investment performance and governance.

### Policy implications and recommendations
- Solvency rules for the PICs would benefit from further changes to avoid short-term focus and historically procyclical behavior promoted by the existing framework.
- Despite changes in 2017, PICs continue to monitor and react to short-term changes in solvency ratios as part of investment strategy.
- Reforms should enable PICs to take a longer-term approach consistent with the long-run nature of their liabilities, potentially enhancing long-term returns and supporting employers, employees, and fiscal sustainability.
- A long-run focus must still consider short-term risk where it creates real issues (e.g., liquidity problems forcing fire sales); short-run volatility is not the same as long-run risk, but liquidity-driven short-run problems justify supervisory intervention.
- Create a unified framework linking short-term supervisory actions to required long-term performance; use short-term monitoring to ensure investment decisions deliver a desired long-term strategic asset allocation.

### Key statistics and dates (as stated)
- 80 percent (correlation surpassing since 2018)
- greater than 90 percent (PIC allocation correlation with certain pension funds)
- close to and above 90 percent (public pension funds’ correlation with all pension insurance companies)
- 1-year solvency focus (regulatory horizon retained)
- 2014 and 2017 (years when PIC investment restrictions were loosened)
- 2018 (reference year for correlation and regulatory pressure changes)
- 1997–2021 (period for private sector pension asset growth)
- over 4 percent real (average asset growth over 24 years since 1997)
- ETK projection rates: 2.5 percent nominal until 2028 and then 3.5 percent thereafter
- Funding ratios at end-2017: 30.6 percent (private sector PICs), 20.7 percent (central government), 38.1 percent (local government)
- EUR 67 billion and EUR 24 billion (sizes of the local government earnings-related pension fund and central government buffer fund)
- 2.8 percent over Treasury Bills over a 20-year period (NZ Super target)
- Market stress episodes noted: 2007–08, 2018, 2020
- ETK October 2022 referenced in analysis

*Source: TELA and IMF Staff Calculations*

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_Source: https://www.imf.org/-/media/files/publications/cr/2023/english/1finea2023006.pdf_