Internal risk assessment

In the following section we compare the available economic capital with the required risk capital.

Hannover Re calculates the economic equity as the difference between the market-consistent value of the assets and the market-consistent value of the liabilities. The corresponding accounting principles also apply largely to the IVC (see the section “Management system”). While fair values are available for most investments, the market-consistent valuation of reinsurance treaties necessitates a specific valuation model. We establish the market-consistent value of technical items as the present value of projected payments using actuarial methods. This is adjusted by a risk loading that factors in the fluctuation in future payments. Such fluctuations result from risks that cannot be hedged by means of capital market products, such as technical risks. In a departure from the measurement rules currently under discussion in relation to Solvency II, we use risk-free interest rates derived from the yields on high-quality government bonds for discounting of our future cash flows.

Market prices for options and guarantees embedded in insurance contracts are determined or approximated using option valuation models from the field of financial mathematics.

The methods used are the same as those adopted in the calculation of our Market Consistent Embedded Value (for further remarks on the Market Consistent Embedded Value please see our comments in the section “Technical risks in life and health reinsurance”). The significance of these options and guarantees in our portfolio is, however, minimal.

The valuation reserves for investments indicate the difference between fair value and book value of those investments recognised under IFRS at book values. Other valuation adjustments encompass above all deferred tax assets and liabilities that arise in connection with valuation adjustments.

The available economic capital increased in the period under review from EUR 10,693.7 million to EUR 11,143.9 million. This was due to the positive effects from economic value adjustments for non-life and life and health reinsurance. In view of the positive business result the shareholders’ equity remained broadly stable despite opposing effects from currency translation and the interest rate environment. The higher interest rates on good-quality government bonds as well as the strengthening euro led to a reduction in the valuation reserves for investments. Conversely, the discounting effect for the loss reserves in non-life reinsurance increased owing to the higher interest rates. The higher value adjustments for life and health reinsurance are attributable above all to lower effects – in comparison with IFRS – from changes in interest rates and exchange rates. The rise in other value adjustments resulted from deferred taxes as a consequence of the higher valuation reserves.

The required risk capital of the Hannover Re Group relative to the target confidence level of 99.97% grew in the year under review from EUR 6,292.1 million to EUR 6,896.9 million. The increase in underwriting risks in non-life reinsurance results largely from the rise in the risk budget for natural catastrophes and from model improvements. By factoring in the increased risk budget we are taking a rather conservative view, since the committed capacities are not fully utilised at all times of the year. The increase in risk capital for market risks is attributable above all to changes in the modelling of credit and spread risks and to an enlarged volume of real estate. The underwriting risks in life and health reinsurance, the credit risks and the operational risks changed in accordance with the underlying business volumes.

The available economic capital, which is available as liable capital for policyholders, is comprised of the economic equity measured as described above and the hybrid capital. The internal capital model is based on current methods from actuarial science and financial mathematics. In the case of technical risks, we are able to draw on a rich internal data history to estimate the probability distributions, e.g. for the reserving risk. For risks from natural perils we use external models, which are adjusted in the context of a detailed internal review process such that they reflect our risk profile as closely as possible. In the area of life and health reinsurance long-term payment flows are modelled under various scenarios. With respect to all the aforementioned risks we use internal data to define scenarios and probability distributions. The internal data is enhanced by way of parameters set by our internal experts. These parameters are especially significant in relation to extreme events that have not previously been observed.

When it comes to aggregating the individual risks, we make allowance for dependencies between risk factors. Dependencies arise, for example, as a consequence of market shocks, such as the financial crisis, which simultaneously impact multiple market segments. What is more, several observation periods may be interrelated on account of market phenomena such as price cycles. In dealing with these dependencies, however, it is our assumption that not all extreme events occur at the same time. The absence of complete dependency is referred to as diversification.

Hannover Re’s business model is based inter alia on building up the most balanced possible portfolio so as to achieve the greatest possible diversification effects and in order to deploy capital efficiently. Diversification exists between individual reinsurance treaties, lines, business segments and risks. We define the cost of capital to be generated per business unit according to the capital required by our business segments and lines and based on their contribution to diversification.