Annual report 2021 KLP Group, Sustainability and KLP

There are no IFRSs or IFRIC interpretations not yet in force that are expected to have a significant impact on the financial statements.

There are changes to standards and interpretations that will have an effect on financial statements beginning after 1 January 2022 which have not been applied to these financial statements. Details of the most important of these that KLP has chosen not to apply early are provided below.

A limited change was made in IAS 1 Presentation of Financial Statements, specifying that debt must be classified as short-term or long-term debt based on the rights that exist at the end of the reporting period. The classification is unaffected by expectations for the entity or events after the balance sheet date (e.g. breach of borrowing terms). The changes also specify what IAS 1 means when it refers to the ‘settlement’ of a commitment. It also specifies that breach of borrowing terms once the period has ended must be taken into account, even though no measurement is performed at this time. The changes may affect the classification of debt, particularly for entities that previously considered management’s intentions in determining the classification, as well as for certain debt items that can be converted to equity. The change must be applied retroactively in accordance with the main rule of IAS 8 Accounting Policies and will enter into force from 1 January 2023.

IFRS 9 Financial Instruments entered into force on 1 January 2018; it covers the classification, measurement and recognition of financial assets and liabilities, and introduces new rules for hedge accounting and a new impairment model for financial assets. Financial assets are classified into three categories:

• Amortised cost
• Fair value with value changes through profit or loss
• Fair value with value changes through other comprehensive income

The measurement category is decided on initial recognition. The classification depends on the business model used by the company/group to manage its financial instruments and the characteristics of the cash flows for the individual instruments. Companies/groups with insurance-dominated activities are granted two alternative temporary exemptions from the new requirements in IFRS 9 under provisions in IFRS 4 Insurance Contracts.

Based on the amended regulations to the Annual Accounting Regulations for life insurance companies of 20 December 2018, Norwegian life insurance companies were not allowed to implement the international accounting standard for financial instruments, IFRS 9. As a result, KLP uses IAS 39 for the recognition and rating of financial instruments as it was before it was amended on 01.01.2018.

In June 2020, changes to IFRS 4 on the extension of the temporary exemption to apply IFRS 9 were published. IFRS 9 will be introduced for all life insurance companies on 1 January 2023. The Company is working on a project to implement IFRS 9 Financial Instruments, and to see what effects the transition to new rules from 01.01.2023 will have.

The new accounting standard for insurance contracts, IFRS 17, was published by the IASB in 2017 and approved by the EU on 23 November 2021. The standard will replace the current standard for insurance contracts, IFRS 4, and will be mandatory from 01.01.2023. The definition of what constitutes an insurance contract has not changed, but there have been some clarifications that limit the qualifying contracts to be handled according to IFRS 17. Unlike IFRS 4, IFRS 17 also contains rules on how insurance contracts should be assessed and presented, as well as extensive new note requirements.

Under the main rules in IFRS 17, insurance contracts should be valued at the sum of:

a. The present value of the future cash flows of insurance contracts (probability-weighted and taking account of time value)

b. A risk adjustment for non-financial risk, and

c. Unearned profits (service margin).

For each period, the calculation of future cash flows (a) and the adjustment for non-financial risk (b) should be based on current estimates. This means estimates that reflect the conditions and expectations for the future at the measurement date. The present value is calculated using market-based discount rates.

The adjustment for non-financial risk should reflect the compensation required by the company for bearing the non-financial risk arising from the uncertain amount and timing of the cash flows. Non-financial risk means any risk associated with insurance contracts that is not financial risk, including insurance risk, the risk of the policy-holder cancelling the contract and the risk of unexpected increases in administrative costs for services associated with the contracts.

The profit element of the contracts is calculated at the time of establishment as unearned profit and is included as a component of the insurance obligation. This component is reduced as profits are recognised where the company has provided services under the insurance contracts. Any negative profit margin (loss) is applied to the profit figure immediately.

There are also simplified models (the premium allocation method) which can be used under certain conditions. The contracts in KLP does not fulfil these requirements , so this method will not be applied.

The standard requires insurance contracts with approximately equal risk managed collectively as a portfolio to be grouped according to whether they are profitable, unprofitable, or profitable with a risk of becoming unprofitable. There may be no more than 12 months difference in the issuance of the contracts included in a group. However, in the EU/EEA area, voluntary exemptions have been granted to allow the contracts to be grouped by year if certain conditions are met.

The standard requires retrospective application, but allows certain simplifications if full retrospective application is not practicable. There should be a high threshold for using the simplifications.

In April 2021, the Financial Supervisory Authority of Norway issued a consultation paper on IFRS adaptation of the annual accounts regulations. This states that it is not permissible to apply IFRS 17 in the company accounts for life insurance companies.

KLP is part of a group where the consolidated financial statements are prepared according to IFRS. This means that KLP has to apply IFRS 17 for consolidation purposes. The principles used in the company accounts therefore have to be aligned with the principles applied at the Group level for consolidation purposes.

The same consultation paper states that large insurers will be required to introduce IFRS 17 at the company level. KLP has a wholly-owned subsidiary, KLP Skadeforsikring AS, which is recognised within KLP according to the equity method. By way of input/response to the consultation, KLP has therefore asked for clarification as to whether life insurance companies that own large non-life insurance companies will have to account for these according to IFRS 4 or IFRS 17. Final rules for how to implement IFRS 17 on company accounts is not finally determined.

The company is part of the Group’s implementation project for IFRS 17. The main product, public-sector occupational pensions (OfTP), is considered to fall within the standard and must be measured using the variable fee approach (VFA), and the contract limit is considered to be long. The contracts are also grouped into portfolios reflecting the current risk groups. KLP’s mutual model raises some particular issues in the implementation of the standard. It is therefore not yet clear how the standard will affect the company’s financial position if it is applied to the company accounts.

On 7 April 2021, the Financial Supervisory Authority of Norway sent an identical letter to all life insurance companies and pension funds concerning pension providers’ treatment of remuneration paid to asset management companies and other managers of mutual funds. In the letter, the FSA states that the management fee paid by a fund to the management company and other managers must be taken into account when determining the price tariff and included in the pension provider’s expenses (gross accounting).

This is not consistent with the KLP’s practice and a change in the principles is expected to have a material consequence for the costs in KLP. However, it is unclear which delimitations apply to costs to be entered gross, so the consequence is not quantified.

There is an ongoing discussion in the industry around this issue, and Finance Norway and others believe, for example, that the FSA’s letter rests on a misinterpretation, and are asking for an explanation of the consequences if the FSA’s interpretation of the law is to be applied.

Otherwise there are no other IFRSs or IFRIC interpretations not yet in force that are expected to have a significant impact on the financial statements.

No changes have been made to the financial statements compared to previous periods.

For financial assets that are not rated at fair value, an assessment is made on the balance sheet date whether objective indications exist as to whether a financial asset or a group of financial assets has declined in value. A certain degree of discretion is assigned to this assessment, as well as factors related to credit, market and liquidity risk.

For the company's portfolio of long-term bonds, including long-term bonds held to maturity, impairment is assessed on an individual basis each quarter. Impairment is calculated as the value of the originally expected cash flow and the new expected cash flow. There will be uncertainty attached to the calculation of a new expected cash flow. Following the outbreak of Covid19 and strong measures to limit the spread of the virus, the economic activity in the bond market has slowed down. No factors or events have been found that would indicate impairment due to a predominant risk of loss in the company's portfolio of long-term bonds.

The insurance provisions are set at the right level of expectation, with the addition of safety margins. KLP can add up to half a year's positive risk results to a risk equalisation fund. This fund can be used to meet unexpected fluctuations in risk results.

For disability risks in the collective pension sector, assumptions are used based on the company's disability experience in the period 2015 - 2019. For other risk elements in the collective pension sector, the assumptions from the calculation basis K2013 are used, with safety margins, according to the minimum standard set by the Financial Supervisory Authority of Norway in 2013. For men, KLP uses its own life expectancy assumptions that assume a greater life expectancy improvement than K2013. In the Pension Scheme for Nurses, the same formulas and parameters are used but with an enhanced safety margin due to significantly longer life spans in these schemes. For the Pension Scheme for Hospital Doctors, K2013 is used with an enhanced safety margin for both genders.

We are currently in a special situation related to corona. At present, there is no excess mortality in the population as a result of the pandemic. If the pandemic should lead to lasting increased mortality, this will give higher risk results. At the same time, there are factors related to the pandemic situation that could affect withdrawals of disability pensions in 2021 and the next few years, such as:

- Layoffs and recessions

- Home office (physically and mentally)

- Extra work in health enterprises

- Lack of capacity of health workers in general

- After-effects of disease

The development of the company's insurance risk is monitored on an ongoing basis. Risk results and future expectations for the development of insured risks are based on observations from the holdings and forecasts from Statistics Norway. These form the basis for the pricing of the risk element of the premium. Premiums are determined annually.

KLP currently only has collective products without the possibility to choose the scope of the insurance cover for the individual insured. Based on this limitation, the size of the company and resulting large risk-bearing ability, the overall assessment is that the need to have reinsurance in KLP is small. KLP currently has no reinsurance agreements.

The effect of an immediate 20 per cent increase in the incidence of disability would, with current numbers, involve a negative effect of NOK 358 million on the risk result for the year. The effect on the premium reserve of a corresponding permanent change in the incidence of disability would be an increase of NOK 726 million.

An immediate 10 per cent reduction in mortality would, with current numbers, mean a negative effect of NOK 307 million on the risk result for the year. The effect on the premium reserve of a corresponding permanent change in mortality would be an increase of NOK 10,786 million.

The Company's large numbers within group public sector pensions help to stabilize the insurance risk and the claim estimates. Deviations are related primarily to non-insurable magnitudes that do not affect the result.

Liquidity risk is the risk that the Company does not have adequate liquidity to cover short-term debt/residual liabilities not called in and current operations without substantial extra costs arising in the form of price falls on assets that have to be realized. The liquidity strategy contains various requirements and limits in order to comply with the desired liquidity risk profile. In addition division of responsibilities and contingency planning are covered. The liquidity strategy is operated at the senior management level and the liquidity is managed internally in accordance with mandates.

The need for liquidity in KLP is first and foremost associated with payments to pensioners and meeting current operating costs. Liquidity is also required for providing security in connection with currency and derivative trades. The KLP liquidity need is primarily satisfied by contractual receipts from customers. At all times the Company has a liquidity holding sufficient to meet current costs, including pension payments. In the event of liquidity needs beyond the current liquidity holdings, liquidity can normally be released through the sale of liquid financial assets.

KLP's aims to have liquidity buffers corresponding to 3 months' expected liquidity needs.

Not-called-in residual obligations of NOK 26,074 million comprise committed, not paid in sums against private equity and property funds and approved lending that has not been paid out. In addition, KLP has given a NOK 2 million guarantee to a associated enterprise. The total is specified in detail in Note 34 Contingent liabilities.

Market risk is the risk of losses as a result of changes in market prices of various assets such as shares, bonds, property and other securities. The market risk depends on how large an exposure there is to the various assets and on the volatility in the market prices. Developments in the Norwegian and international securities markets generally have major significance for KLP's results.

Risk of a fall in the value of various assets is the biggest financial risk in the short term. Of the risk in regard to assets, equity exposure is the largest financial risk factor, but also the market risk associated with interest, credit (spread) and property has a significant loss potential. KLP's interest rate risk associated with a prolonged low interest rate level is however limited. With the current formulation of the rules, technical provisions are not affected by changes in market interest rates. On the future transition to market value for the liabilities, annual pricing of the interest guarantee will mean the customers bear the risk of the interest rate level being lower than the basic interest rate. Since KLP provides pension schemes exclusively to the public sector, KLP will price the return guarantee right up until the insured dies, which means the return guarantee arising from the insurance obligations is limited.

KLP exchange-rate hedges the majority of international exposure. Financial hedging of currency exposure is done through derivatives. In principle all of KLP's fixed-income investments and property investments in foreign currency are hedged back to NOK. For equity investments in foreign currency the hedge ratio in 2021 has been between 50-70 per cent.

All equity and interest rate exposures are included in a risk measurement system that enables simulation and monitoring of equity and interest rate risk across the portfolios. Active risk is managed through defined benchmarks relative to the index for each portfolio.

To reduce the risk of negative results from asset management the Company uses CPPI rules for customer portfolios for daily monitoring the market risk. This strategy helps to ensure that the risk is adjusted to the Company's risk capacity. The CPPI rules gives a return profile wich fits the overall target to protect owners' equity and preserve the risk capacity over time. In addition KLP has a high proportion of long-term (hold-to-maturity) bonds and fixed-interest lending that contributes to stability in returns.

In KLP's asset management, derivatives are principally used for risk reduction for cost and time-effective implementation of changes in risk and for currency hedging.

Calculation of solvency margin (SCR ratio)

The European rules for calculation of solvency margin, SCR ratio, main target is to protect and ensure the interest of the insurance customers. KLP performs quarterly calculations of the SCR ratio.

At the end of 2021 about 30.9 per cent of KLP's assets were placed in equities (measured by exposure) and 13.8 per cent placed in property. Other assets were placed in fixed-income current and fixed assets, including lending.

According to the standard calculation method, KLP has a SCR ratio of 316 per cent, which is 34 percentage points higher than the end of 2020. The ratio is well over the Company's target of at least 150 percent in 2020. The minimum target set by the authorities is 100 per cent.

The Company's' total eligible tier 1 capital is 45 billion. The solvency capital requirement, as described in note 32, is NOK 14.0 billion. The SCR ratio in 2021 was 316 per cent.

Several sensitivity analyses linked to solvency capital coverage have been carried out. Interest rate sensitivity is calculated at 6 percentage points in capital coverage per 50 basis points interest rate increase and 7 percentage points in capital coverage per 50 basis points interest rate decrease. This may be considered low, at least compared to private occupational pensions, and is mainly due to the fact that public-sector occupation pensions avoid the problem of paid-up policies. A 25 per cent fall in the stock market reduces capital adequacy by something over 50 percentage points when the rules are taken into account. This is a significant drop, but the level of capital adequacy will still be above the level at which action has to be considered.

Previous calculations has shown that with the reserve margins within the Company's tariffs and by the level of todays risk equalization fund, the solvency capital is marginal influenced by changes in longevity risk and mortality/whole life risk.

Emphasis is placed on diversification of credit exposure to avoid concentration of credit risk against individual debtors. To monitor credit risk in lending and investments a special credit committee has been established, meeting regularly. The limits for credit risk against the individual debtor are set by the committee. Changes in debtors' credit assessments are monitored and followed up.

KLP has good balance between Norwegian bonds and international bonds and has a portfolio of exclusively good credit notes. Of the total credit exposure, 41 per cent are rated AA- or higher.

KLP has a lending portfolio of high quality, with limited credit risk and historically very low losses. In the main KLP provides loans secured on housing with a mortgage level of less than 80 per cent, loans to local authorities and loans with local authority guarantees. Lending secured through mortgages on housing amounts to about NOK 3.0 billion. The value of the mortgages represents a greater value than the lending since a large part of the mortgages were established earlier in time and the price rise in housing in recent years has been substantial.

KLP has limited concentration risk. Because no exposures exceed the threshold values defined in the Solvency II regulations, KLP has no capital requirements for concentration risk under the standard method. The way in which the fixed interest and equity portfolios are managed will generally help to limit concentration risk through extensive use of index management. KLP sets explicit limits for lending which restrict concentration on specific individuals and groups. Sector concentration is monitored via monthly and quarterly reporting.

Although the KLP’s investments are well diversified, there is a clear preponderance of investments in Norway. This is a deliberate and a natural consequence of dealing mainly with public-sector occupational pensions.