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Quantitative risk management methods

For many years Hannover Re has managed and monitored its risks with the aid of quantitative methods. In this context, Hannover Re’s internal capital model is one of the central tools. It constitutes a uniform mathematical framework for the evaluation of all risks affecting the company. In this way, the costs associated with a risk – the cost of capital – can be consistently broken down to all operational areas of the corporate group.

The internal capital model of Hannover Re is a stochastic enterprise model. It is able to determine the effect of a large number of scenarios on key performance indicators and balance sheet ratios. In this context, an economic valuation approach is practised that in many respects corresponds to the business valuation likely to be adopted in future under Solvency II. On the basis of methods used in actuarial science and financial mathematics, scenarios are generated for technical risks, market risks, credit risks and operational risks – making allowance for the dependencies between these risks. Last but not least, the model enables us to verify whether the level of available economic capital exceeds the capital required to operate the business at all times. Hannover Re calculates the required capital as the Value at Risk (VaR) of the economic change in value over a period of one year with a confidence level of 99.97%. This reflects the goal of not exceeding a one-year ruin probability of 0.03%. The internal target capitalisation is therefore significantly higher than the future requirements under Solvency II, where the confidence level is 99.5%.

The requirements placed on the existing risk capital rose slightly in the year under review from EUR 5,410.7 million to EUR 5,484.7 million. This increase reflects the enlarged business volume in the non-life and life/health reinsurance business groups. The increased credit risk is attributable inter alia to a rise in reinsurance recoverables due to the use of retrocession in the 2011 financial year. The market risks give rise to an effect that runs contrary to the increase in required risk capital for the non-life and life/health reinsurance groups. The required risk capital for market risks is lower because Hannover Re progressively reduced its equity allocation in the year under review.

Available capital and required risk capital1 in EUR million 2011 2010
The required risk capital is the Value at Risk for the confidence level of 99.97% of the potential change in value over a period of one year.
Underwriting risks in non-life reinsurance 3,048.3 2,905.3
Underwriting risks in life and health reinsurance 2,029.1 1,961.8
Market risks 1,992.2 2,440.1
Credit risks 569.4 406.5
Operational risks 408.6 314.9
Diversification effect (2,562.9) (2,617.9)
Required risk capital of the Hannover Re Group 5,484.7 5,410.7
Available economic capital 8,758.7 8,381.7
Capitalisation ratio 159.7% 154.9%

The available economic capital increased in the observation period from EUR 8,381.7 million to EUR 8,758.7 million. This was principally due to the positive business result for 2011 despite the heavy burden of major losses. The change in the economic environment in 2011 – with sharply lower interest rates and higher credit spreads – led to an increase in the valuation reserves for investments and a reduction of the valuation adjustments for non-life reinsurance. The valuation reserves for life and health reinsurance climbed above all due to the positive development of new business.

Reconciliation (economic capital/shareholders’ equity) in EUR million 2011 2010
Shareholders’ equity 5,606.7 5,117.9
Value adjustments for non-life reinsurance 1,262.8 1,490.2
Value adjustments for life and health reinsurance 751.6 675.8
Value adjustments for assets under own management 368.8 232.5
Tax effects and other (962.8) (1,003.8)
Economic equity 7,027.1 6,512.6
Hybrid capital 1,731.6 1,869.1
Available economic capital 8,758.7 8,381.7

The increase in the available economic capital and the parallel merely modest rise in the required risk capital pushed the coverage ratio higher to 159.7%. The Hannover Re Group thus continues to be very well capitalised.

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. While fair values are available for most investments, the market-consistent valuation of reinsurance treaties necessitates a suitable valuation model. We establish the market-consistent value of technical items as the present value of projected payments using actuarial methods adjusted by a risk loading that factors in the fluctuation in future payments. These fluctuations result from non-hedgeable risks such as technical risks. For the life reinsurance line we additionally use valuation principles similar to those set out by the Chief Financial Officer Forum for the calculation of the Market Consistent Embedded Value (MCEV). This valuation method discloses the capital reserves that are not revealed by the measurement rules under IFRS. The valuation reserves for investments show the difference between the fair values and book values of our assets under own management. Other valuation adjustments refer principally to deferred taxes in connection with the valuation adjustments.

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.

As already explained, the internal capital model of Hannover Re covers technical risks, market risks, credit risks and operational risks. These risks are carried over to Hannover Re’s risk map and further broken down, e.g. into interest rate risks, catastrophe risks and reserving risks. Dependencies exist between these risks, which Hannover Re takes into account in order to adequately establish its target capitalisation. Dependencies arise, for example, as a consequence of market shocks such as the current 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.

Diversification effect within the non-life reinsurance business group

Diversification effect within the non-life reinsurance business group enlarge zoom

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 as well as their contribution to diversification.


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