Good morning everyone and a warm welcome to Arion banki presentation for the third quarter and nine months results. My name is Benedikt Gislason, I'm the CEO of Arion . Today's agenda is as follows. I'll start by walking you through the key highlights from the quarter, our outlook going forward, and a deeper dive into some of the highlights. Then our Chief Economist Erna Bjorg Sverrisdottir will provide a brief update on the Icelandic economy before we go to a Q and A, so expect a slightly shorter presentation than in previous quarters for the Q and A. I would like to remind our participants online that you can submit questions throughout the presentation via a message board located below the video feed. We will provide answers to your questions in the Q and A session at the end of the webcast.
First of all, we are very happy with the solid results in the quarter and positive nine months of the year, which is a collective success of all our employees that have worked tirelessly to deliver good services to our clients. The return on equity in the quarter was 16%, the same as for the nine months, which is well above our medium term targets of 13%. We saw good momentum in core earnings mostly due to higher net interest income, which grew 6.9% year- over- year, resulting in core operating income against risk exposure amount of 7.4% and well above our financial target there. There has been a moderate insurance premium growth in a highly competitive market driven by increase in bancassurance ratios during the first nine months.
Our focus here is on profitable growth and Vörður had a strong first nine months with combined ratio of 88.2%, which is below the 95% medium term financial target. Development in expenses has been within expectations with expenses increasing 2.9% in the quarter, well below the inflation rate of 4% and resulting in the lowest cost to core income ratio that we've seen. This item is however very seasonal. Capital optimization is on track and is moving closer to an optimized level. CRR3 implementation later this year is expected to further increase surplus capital of ISK 10 billion following our capital distribution in the second quarter. We expect Kvika merger to further increase capital level from current standalone position and we enjoy currently a strong capital and liquidity position, which is very comfortable in the current operating environment. Today we are launching a new Arion Rewards Savings account.
This account offers top tier interest rates that are paid weekly and available exclusively to our rewards members with competitive deposit rates depending on the amount and the customer's tier within the rewards program. Interest is paid weekly on this account, delivering compound interest which increases the overall savings rate. This is a great opportunity for our clients to maximize their savings while enjoying the benefit of being part of Arion Rewards. Other notable highlights in the quarter.
The successful issuance of EUR 300 million in senior preferred notes with a six-year maturity. This was the bank's longest senior financing to date, with strong participation from investors from more than 20 countries across EMEA and APAC, with a spread of 120 basis points. Our pension fund services continue to grow, with FR Pension Fund and the Dentists’ Pension Fund agreeing to merge, creating a stronger combined entity. If we look further around our asset management services, Stefnir saw strong momentum with the launch of CF5, a new ISK 15 billion private equity fund focused on investing in unlisted Icelandic companies. Secondly, by implementing targeted fee reductions and leveraging the Arion Rewards program, Stefnir has enhanced transaction accessibility, transferred operational efficiency to its clients, and achieved a 9.1% year-to-date growth in its client base.
Thirdly, Stefnir introduced a new fund called RAID20, which partners with buyers of residential real estate by contributing 20% co-ownership, allowing our clients to own 80% with full control. In terms of markets, assets under management and supervision grew by 4.7% in the quarter, and assets under management and services assets under management up 11.7%, and institutional assets under management reaching ISK 950 billion. Finally, Arion was once again awarded first place for excellence in business in Iceland, marking the fourth consecutive year of recognition. The Consumer Association's class action lawsuit against Icelandic banks has been ongoing for a few years, as illustrated in this slide. We are currently waiting for a Supreme Court ruling on our variable CPI-linked mortgages case. The hearing is scheduled for November 17, and the ruling should arrive before the holidays. In this case, Arion.
has been acquitted in the lower courts. Should the Íslandsbanki ruling be applied to Arion non-indexed loans, the estimated loss would be less than ISK 500 million pre-tax. However, for the indexed loans where uncertainty prevails, the estimated worst-case scenario could result in a pre-tax loss of up to ISK 4.5 billion, assuming the lowest interest rates presented by the Central Bank. Other scenarios yield a considerably lower outcome. We have not made any provisions in respect of impending court cases given the degree of ongoing uncertainty, but we'll keep this under review. Following the Supreme Court ruling, Arion banki hf. suspended its CPI-linked mortgages loans offering, but preparations are underway for a temporary solution regarding issuance of CPI-linked loans. As most of you know, we are in the midst of an important merger discussion with Kvika. Over the past few months, we have made significant progress.
Right now, we are focused on two critical steps: completing the due diligence process and engaging in pre-notification discussions with the Icelandic Competition Authority. These conversations will take several weeks and are essential for assessing competition matters. The outcome will determine whether we move forward with the merger. If these steps are successful, the next phase will involve signing the merger agreement and notifying regulatory bodies. Following that, we will seek regulatory approvals, hold shareholder meetings, and issue new Arion banki hf. shares to Kvika shareholders. Although we are making good progress and are optimistic, we should note that this is a structured process where the decision to proceed ultimately depends on the results of the due diligence and regulatory dialogue. We expect to have further clarity on that in the coming months.
I'm pleased to share with you that the sale of Artnaland, a development asset in the suburban area south of Reykjavík, was successfully finalized last week following a structured and diligent process. While the financial impact in the fourth quarter accounts will be positive but minimal, the strategic significance of this project is clear. The sale crystallized ISK 2 billion of gains for our shareholders in the first nine months and is a prime example of our ability to create value through careful development and execution from start to finish. This project should be viewed in the context of our other key land development asset, Blekastaðir, which is a much larger project currently in its first district planning development phase. Now going to the key takeaways for the third quarter, starting with some of the key highlights.
As previously mentioned, a strong quarter with a return on equity to shareholders of 16%. The results in our core income are primary reasons for these strong earnings. Good quarter in interest margin with rather high inflation and contribution from lower funding costs as well. Solid quarter in terms of fee generation and insurance services, results being stable with combined ratio in our insurance business of 88.2% in a quarter. Healthy corporate loan growth demonstrated again in this quarter while economic activity is slowing. This growth is supported by continued momentum in deposit growth. It's worth noting that cost of risk has consistently been below provision levels, but expected loss is however rising amid challenging economic environment. Finally, our capital position is trending near target of the bank with CET1 ratio of 18% and liquidity position remains robust following successful funding activities in the first half of the year.
We've already pre-funded our senior preferred issuance with maturity date next year, and there is also maturity of covered bond in the third quarter of 2026, which we have started preparations for. Looking briefly at the income statement, core income, namely net interest income, fees, and insurance revenues, were ISK 19.3 billion in the quarter, which is up from ISK 18 billion in Q3 2024, or up by 6.9%. As previously mentioned, net interest income was up by 16.9% between the years and fees were up 3.2%. Financial income was impacted by rather slow equity markets, resulting in ISK 483 million income, including the investment portfolio of the insurance business and our market making. Operating expenses increased by 2.9% as previously mentioned, whereas inflation was up 4%. Net impairments in the quarter calculates at 35 basis points of the loan book on an annualized basis.
This is slightly above the calculated expected loss, but has consistently been below provision levels. Expected loss is however rising due to the challenging economic environment, and the effective tax rate was 26.3% in the quarter, which is close to the expected rate, resulting in a net profit for the quarter of ISK 8.2 billion, compared with ISK 7.9 billion for the third quarter of last year, which is an increase of 5%. I would also want to mention that the earnings per share increase is somewhat higher due to few outstanding shares, going from ISK 5.62 in the third quarter of last year to ISK 5.95 now. I'm going to skip this slide here and go to the loans to customers, which grew by 3% in the quarter or ISK 29 billion. This is primarily related to new lending on the corporate side.
As previously guided, we've taken a thoughtful approach to loan growth with a clear intention to remain selective in our lending activities in current economic cycle. Over recent quarters, growth has primarily been driven by our corporate business where we've been seeing some interesting opportunities, and we expect actually this trend to continue given the current situation in the mortgage market following the recent Supreme Court ruling. The loan book, however, continues to be well balanced with 44% in mortgages, 6% in other loans to individuals, and 50% to corporates. Final two slides before I summarize and head over to Erna on the risk profile: we saw a ISK 1.1 billion impairment in the quarter, which is mainly due to calculations from our provision models.
With the economic environment slowing down and the situation of companies and individuals worsening, non-performing loan ratio has increased since year end 2022, although not from last quarter. I think it's important to highlight that the total loss allowance at the end of the quarter is ISK 10.3 billion or 79 basis points of the loan book, slightly higher than in recent quarters. Now going to the capital adequacy and CRR3. In particular, we are now currently at 266 basis points above regulatory requirements, which is still above our 150 to 250 basis point target, including the management buffer as outlined in previous presentations. We've been expecting a positive capital impact from the CRR3 implementation, which we now expect to be implemented before year end 2025. The initial impact on capital relief is now anticipated to be approximately ISK 10 billion.
To summarize, before I hand over to Erna, I wanted to highlight some of the key themes going forward. Strong operating performance for the first nine months with core business providing good earnings, and the diversity of our business provides support for the overall earnings momentum through the cycle. We continue to cautiously anticipate a continuing complicated external operating environment near term, both in terms of domestic rate development and in terms of the international landscape. Finally, the proposed merger with Kvika is on track. It will provide numerous opportunities to further strengthen our business and our services to our clients. Now I would like to welcome our Chief Economist, Erna Bjorg Sverrisdottir, to the stage before we move on to the Q and A session. Welcome.
Thank you. Benedikt Gislason. Good morning all. It's good to be with you all here today. I'd like to begin with a statistic that might surprise you, or maybe not, given the weather outside. In 2025, an average of 16% of Iceland's population has been abroad. Each month, Icelanders are traveling more than ever before, surpassing even the record year of 2018, reflecting the robust financial position of households and a strong krona. It's no surprise that service imports have surged up 10% in the first half of 2025. Goods imports have increased even further during the same period, up 15%, largely driven by significant imports related to data centers. These two factors, travels and data centers, largely explain the 1.9% contraction in the second quarter. Here I have to emphasize that these are preliminary figures and I can almost guarantee that they will change.
For example, the surge in computer imports has yet to translate to proportional business investment, which means that currently the contribution of data centers to GDP is negative. Despite the measured contraction in the second quarter, the economy cannot be characterized as subdued, as private consumption increased by 3.1% and investment rose 8.3%. Furthermore, service exports increased by 4.2%, thanks to an exceptional summer for tourism. This trend has persisted into the third quarter, with Icelanders' payment card turnover up 5.3% between years, alongside record tourist arrivals and hotel occupancy. However, in the past five weeks much has changed and our three big export sectors are all facing an uphill battle. Earlier this autumn, PLAY Air's bankruptcy was announced. According to our calculations, PLAY share in tourist arrivals had fallen below 10%, so the immediate hit to Icelandic tourism should be limited.
We expect tourist arrivals to drop slightly in the fourth quarter, which was expected regardless of PLAY bankruptcy, and the number of visitors next year to remain broadly unchanged between years. Although the impact on tourism is limited, the bankruptcy will have a negative impact on exported services, overseas travel by Icelanders, possibly short-term inflation through airfares, and unemployment. The bad news unfortunately kept coming because one day after PLAY Air's bankruptcy, the ICES issued a guidance indicating a 70% cut in the mackerel quota and a 41% reduction in the blue whiting quota. Despite increases in herring and capelin, the net impact on the seafood industry is negative. As the old saying goes, when it rains, it pours. Last week, Norðurál, the aluminium smelter at Grundartangi, announced that it was forced to temporarily stop production on one of its two pot lines due to an electrical equipment failure.
As a result, production of the smelter has been temporarily reduced by approximately 2/3. This is a severe hit as Norðurál is one of the largest export companies in Iceland. It accounted for 11% of total exports of goods in 2024 and it employs almost 700 people. The export prospects have clearly deteriorated and unemployment will likely continue to inch upwards. The labor market was already showing signs of moderation. Private sector employment had fallen between years. Total housework job vacancies have declined in number, and according to the Gallup survey, fewer firms are interested in recruiting workers. Moreover, there have been several collective redundancies which have yet to show up in the unemployment figures. Currently, unemployment stands at 3.5%, up from 3.3% at the same time last year, and is expected to go well above 4% in the coming quarters.
Even though the labor market has softened, wages have increased significantly, boosting purchasing power and supporting private consumption. The steep pay rises have also had a clear impact on the domestic portion of inflation. Headline inflation has proven persistent and the last stretch toward the inflation target appears to be challenging. Inflation measured 4.1% in September and is expected to remain around 4% until the first quarter of next year. In addition, inflation expectations are still well above target. Therefore, it's unlikely, at least in my opinion, that the MPC will lower rates at their next meeting in November. Although it's not entirely ruled out, in my opinion, it's slightly more likely that the MPC will keep rates unchanged but soften its tone significantly due to the worsening economic outlook. However, there is no denying that rate cuts have certainly moved closer in time.
While the progress in curbing inflation and anchoring inflation expectations has been slower than anticipated, the tight monetary stance has had tangible effects, most notably in the housing market. Supply of new housing has continued to accumulate. The average time to sale for newly built homes has grown significantly longer. However, there are still no signs of distressed sales and nominal prices are still increasing. That might change following the ruling of the Supreme Court of Iceland in an interest case against Arion banki . Most lenders have already responded by changing their loan offerings, most notably by restricting access to CPI-linked mortgages. This changing landscape in the mortgage market could prove challenging for some households and could accelerate the cooling of the housing market, which could pass through to domestic prices and lower inflation. Interest rate cuts have certainly moved closer in time.
There are a lot of moving pieces and uncertainty is high. I would like to finish this presentation by reminding you that the fundamentals of the economy remain strong and both households and businesses continue to demonstrate remarkable resilience. Furthermore, the Central Bank is well positioned to respond to potential shocks with ample flexibility to react both through monetary policy and macroprudential instruments. That concludes my presentation. We will move on to the Q and A session. I would like to welcome Eike Tietz, our Deputy CFO, to join us in the panel and welcome our Head of Corporate Communication, Charles de Guigné Eiríksson, to the stage to lead the questions. Thank you.
Good morning everyone. As usual, we will start with some questions from our online participants, and we have some questions from Alexandra. Four questions, and we'll just take them one at a time. Are you worried about the current situation on the residential real estate market and the implications for your business?
I think all uncertainty is bad for business. I think the next Supreme Court ruling will be essential in sort of c larifying the legality of variable CPI-linked. Mortgages and give us, I guess, some of the guidance to how those products might be offered to our clients going forward. For the time being, this is clearly going to have an impact and setback when it comes to activity in the residential real estate market.
Can you comment on whether the government's actions presented yesterday will have any impact on your appetite for resuming issuing CPI-linked mortgages?
I think it's important to highlight that the legality of the CPI variable rate still remains a question, and what the Supreme Court might find as an appropriate reference topology, also rate tensors. We welcome any effort b y the authorities to come up with an instrument or structure that could provide us with a reference. I would, however, want to highlight the fact that we are market makers in government funds and a lot of activity goes through our participation in the stock exchange in the bonds that might be referenced here, which poses another kind of potential risk for us.
The third question, increased loss allowance on the individual loan book. Does that reflect that general deterioration in the economic outlook, or is it driven by specific reasons such as higher unemployment?
The provision for the individuals has been q uite stable since 2023, and we don't see any shift in that during this quarter. This is just a minor change from prior periods, so we don't see any shift in that at this point in time.
Final question from Akur regarding corporate loan growth. You mentioned that the growth rate in coming quarters is not expected to continue at current levels. Can you give any guidance on the levels to expect?
We are expecting a growth in our corporate lending activity, and I think it's a mixture of certain industries that still are investing despite the current economic uncertainty. Projects that are ongoing will continue to be sort of developed. I think secondly our growth is t o come from increased market share. Certain areas l ending and successfully been. Develop s ort of bringing on new larger corporate clients as well.
We have a few questions from Violeta Baraboy from SofGen. First question, any appetite for further wholesale funding this year?
As we mentioned, we pre-funded all of our senior unsecured liabilities for next year. What we're currently looking at is to refinance the ISK 500 million benchmark of covered bonds maturing in the third quarter of next year. We will, as always, seize the opportunity when we think the markets a re favorable for that It's a big benchmark issue, and our plan is to continue to issue covered bonds in the international market.
Second question, what is the timeline for potential provisions on class action?
Yes, as outlined in the presentation, I wait for the ruling in the Supreme Court, which should come in December, mid-December, and that will clearly be a sort of data point that will impact impairments permanently.
Third question, are you seeing any further deterioration in asset quality into the fourth quarter and estimated cost of risk next year?
Yeah, we have guided for the estimated cost of risk through the cycle to be around the 30 basis point level. I think it's moved from 29- 31. In recent quarters, and that sort of continues to be our guidance. For t he cost of risk. I think we're pretty well provisioned, and we like to provision ahead of time as well. As I mentioned, the overall provision is 79 basis points as a credit portfolio. Anything you want to add?
No, I think updated cost of risk is 31 basis points from 28 last year. That's a slight change between years.
Okay, that concludes the online questions. Are there any questions from the auditorium?
Two questions. First, on the slowing corporate loan growth, what's driving that and could you put. Into a full new economy and second on the lawsuit and what effect it could have on your interest income. Just like you see maybe fewer CPI-linked mortgages, more fixed rates, and then also maybe higher spread on gold tax and loans like that you have on the default.
Maybe start with your second question. There were two questions here. One on sort of the changes in the mortgage market and what has an impact to interest income and activity going forward. The first question was around the corporate lending market, potential slowdown there. I think the w hat will probably come out of the Supreme Court rulings, the other ones that we're waiting for, is that wider use of CPI-linked mortgages will decrease. For us that's beneficial because.
This t he surge in demand for CPI-linked mortgages has really impacted our asset liability management. It's challenging to balance between CPI-linked assets and liabilities, and it's created volatility in our income. We've had quarters which have posted lower NIM that we're fighting for and other quarters where the NIM is higher. We're hoping that this will bring stability to our quarterly results going forward. It will take some time to transition, but I'm sure that this market will r emain and continue to be highly competitive.
We're competing with more than 20 mortgage providers, and this is a sawdown after asset class. I'm sure that competition will sort of drive margins to at least similar leverage as previously, even market pressure. Obviously, the CRR3 impact as well is probably going to benefit clients or mortgage borrowers positively as well. The capital requirement eases on mortgages with lower LTVs.
On the corporate side y ou know, it's really hard to read into this, but as I said, I think there are still certain industries that investments are continuing. Investors or corporates seem to have decent access to financing. They can raise capital for these projects and the national cycle will continue. I think the sector that we're probably most concerned about at the moment is the construction sector. There is relatively sort of large supply of new built housing already unsold in the market and current interest rate environment. The cost of new building, also, development is obviously relatively high compared to what it was two, three years ago. We've done a stress testing of t hat portfolio, and we've been comfortable with our exposure there. We're not anticipating any more near term to come from residential real estate development. As I said, there are other industries that still show relatively good sort of momentum in their investment activities and sort of borrowing needs.
Any further questions from the auditorium? If not, I thank you all for joining this morning, and I hope you enjoy the rest of the day. Thank you.