Earnings Logic and Risks
Sampo Group is involved in three business areas: P&C insurance and life insurance are conducted by subsidiaries If P&C Insurance Holding Ltd and Mandatum Life Insurance Company Ltd that are wholly owned by parent company Sampo plc. In addition to the insurance subsidiaries, Group's parent company Sampo plc also held, as at 31 December 2011, an equity stake of 21.28 per cent in Nordea Bank AB (publ), through which Sampo Group has an exposure to banking activities. Nordea is an associated company affecting Sampo Group's profits and risks substantially. However, it is an independent company whose risk management is not covered in Sampo Group's annual report.
Sampo plc as a parent company does not have any business operations of its own except the management of its capital structure and liquidity buffers. Sampo plc guides the activities of subsidiaries by setting financial and capitalization targets for the subsidiaries and defining the group level principles for instance in the areas of risk management, compensation and compliance. The subsidiaries organize their operations taking into account the special characteristics that arise from the company specific earnings logic and risks, in addition to targets and principles set by the parent company.
As a pan-Nordic insurance group If P&C underwrites policies that cover various risks of individuals and corporations on a geographically diverse area. If P&C mainly underwrites insurance risks in the Nordic and Baltic countries, as well as policies for Nordic clients with operations outside the Nordic countries. In addition to geographical diversification, the business is well-diversified over lines of business. Mandatum Life operates in Finland and Baltic countries and offers savings and pension policies with life risk features, as well as, separate policies covering mortality, morbidity and disability risks.
If P&C and Mandatum Life are exposed to various risks, which are selected carefully and priced reflecting the inherent risk levels. Reinsurance is used to reduce exposure to low frequency, but high impact events. A critical success factor is also the companies' ability to optimize the balance between the expected returns and risks in investment portfolios while taking simultaneously into account the features of insurance liabilities, solvency, regulatory asset coverage rules and rating requirements. The core competencies in subsidiary companies are the pricing of insurance risks, evaluation of investment risks, the proper management of the arising risk exposures and the ability to manage adequate balance between risks and capitalization.
The parent company Sampo plc aims to ensure that the activities of the subsidiaries will not lead to unwanted risk concentrations and hence, for extra need of capital at group level. Firstly, the concentrations are pro-actively prevented by careful division of risk-taking between subsidiaries, and secondly the risk profiles of subsidiaries are adjusted if needed.
Sampo Group’s main risks are illustrated in figure 'Categorization of risks in Sampo Group'. The risk categorization is mostly based on sources of risks. Under P&C insurance underwriting risk the categorization is based on the practices of the administration of risk instead. This categorization distinguishes between risks of claims, which have already happened in the past (reserve risk), and the risk of claims, which will happen in the future (premium risk). Independent of this categorization the unique risk sources like fire, motor accident, windstorms and catastrophic events are similarly causing deviations from the expected values as in any other risk category. Moreover, risks such as ALM risk, concentration risk and reputation risk are by their nature linked to various risk factors simultaneously.
P&C insurance underwriting risk:
Premium risk is the risk of loss due to inadequate pricing, risk concentration, improper reinsurance coverage or random fluctuations in frequency and/or size of claims.
Reserve risk results from fluctuations in the timing and amount of claim settlements.
Catastrophe risk is the risk of low frequency, high severity events, such as natural catastrophes, that are not captured adequately by the premium risk or reserve risk. These events lead to significant deviation in actual claims from the total expected claims. Catastrophe risk is not defined as a separate risk, but it can be seen as an extreme case of premium risk.
Expense risk arises from the fact that the timing and/or the amount of expenses incurred differs from those expected. As a result expense charges originally assumed may not be enough to cover the realized expenses.
Life insurance underwriting risk:
Biometric risks refer to the risk that the company has to pay more mortality, disability or morbidity benefits than expected or the company has to keep paying pension payments to the pension policyholder for a longer time (longevity risk) than expected when pricing the policies. The specific case in which a single event of major magnitude leads to a significant deviation in actual benefits and payments from the total expected payments is called catastrophe risk. In life insurance, catastrophe events include single events or series of events. These events can occur within short time period or be, by nature, long-lasting events.
Policyholder behavior risks arise from the uncertainty related to the behavior of policyholders. Policyholders have a right to cease paying premiums (lapse risk) and a possibility to interrupt their policies (surrender risk).
Expense risk arises from the fact that the timing and/or the amount of expenses incurred differs from those expected at the timing of pricing. As a result expense charges originally assumed may not be enough to cover the realized expenses.
Market risks refer to fluctuations in the financial results and capital caused by changes in market values of financial assets and liabilities as well as in insurance liabilities. Market values change together with underlying tradable market risk variables of which the following ones are currently the most important for Sampo Group: interest rates, inflation, credit spreads, foreign exchange rates, share prices and their volatilities.
Credit risk (default) refers to the negative impact in the financial results arising from defaults of debtors (issuer risk) or other counterparties (counterparty risk in derivatives and reinsurance contracts). Credit risk may realize when the cash flows agreed with the debtor or counterparty fail to materialize. In the case of issuer risk the final loss depends on the company’s holding in the security and the recovery rate. In the case of counterparty risk, final loss depends on potential positive mark-to-market value at the time of default together with recovery rate.
Liquidity risk is the risk that insurance undertakings are unable to conduct their regular business activities in accordance with the strategy, or in extreme cases, are unable to settle their financial obligations when they fall due. Liquidity risk deals with potential illiquidity of investments and non-renewal of insurance policies. Also the availability and price of refinance and financial derivatives affect the company´s ability to carry out regular business.
Operational risk refers to the risk of loss resulting from inadequate or failed processes or systems, from personnel and systems or from external events. This definition includes legal risk but excludes risks resulting from strategic decisions. Compliance risk is the risk of legal or regulatory sanctions, material financial loss or loss of reputation an undertaking may suffer as a result of not complying with laws, regulations and administrative provisions as applicable to its activities. A compliance risk is often the consequence of a legal or operational risk and hence it can be seen as a part of operational risk.
General business risk:
General business risk is the risk of losses due to changes in the competitive environment or internal flexibility. Unexpected changes in general business environment can cause bigger than expected fluctuations in financial results. Such changes include the general economic development, changes in the institutional environment, technological innovations and competitive factors such as new competitors and changes in margins and volumes.
The company is exposed to ALM risk when changes in different market risk variables (e.g. interest rates, inflation, foreign exchange rates, equity prices) cause a change in the value of investment assets that is of different size than the respective change in the economic value of insurance liabilities. In addition, the cash flows of technical provisions are modeled estimates and therefore uncertain in relation to both their timing and amount. ALM risk also includes this component of uncertainty.
Concentration risk arises when the company´s risk exposures are not diversified enough and as a result of this an individual claim or market event could threaten the solvency or the financial position of the company. Concentration risk may realize also when the profitability and capital position is reacting similarly to general economic development or to structural changes in institutional environment in different areas of business.
Reputational risk, which is not categorized as an operational or a compliance risk, is the risk of reputational damage due to an action or event.
An illustrative picture of the most significant risks in Sampo Group is presented in figure 'Key risks in Sampo Group'. The most significant risks when Nordea's figures are included are credit risk, market risk, insurance risk and operational risk. The figure is for illustrative purposes only.
The most significant risk arising from the operations of the insurance subsidiaries is market risk. On the Group level, the most significant risks are market risk and credit risk. This is due to Sampo plc's holding in Nordea whose business activities in banking result in credit risk being the key risk.