Derivatives are financial instruments, the fair value of which is derived from an underlying instrument such as equities, bonds, indices or currencies. We use derivative financial instruments in order to hedge parts of our portfolio against interest rate and market price risks, optimise returns or realise intentions to buy/sell. In this context we take special care to limit the risks, select first-class counterparties and adhere strictly to the standards defined by investment guidelines.

The fair values of the derivative financial instruments were determined on the basis of the market information available at the balance sheet date. Please see Section 3.2 “Summary of major accounting policies” with regard to the measurement models used. If the underlying transaction and the derivative are not carried as one unit, the derivative is recognised under other financial assets at fair value through profit or loss or under the other liabilities.

Hannover Re holds derivative financial instruments to hedge interest rate risks from loans connected with the financing of real estate; these gave rise to recognition of other liabilities in an amount of EUR 3.2 million (EUR 2.3 million).

Hannover Re’s portfolio contained derivative financial instruments as at the balance sheet date in the form of forward exchange transactions predominantly taken out to hedge cash flows from reinsurance contracts. These transactions gave rise to recognition of other liabilities in an amount of EUR 20.7 million (other liabilities of EUR 34.9 million).

Hannover Re also holds derivative financial instruments to hedge inflation risks associated with the loss reserves in the technical account. These transactions resulted in the recognition of other liabilities amounting to EUR 32.5 million (EUR 31.4 million) and other financial assets at fair value through profit or loss in an amount of EUR 12.2 million (EUR 0.2 million).

The fair values and notional values of the hedging instruments described above can be broken down as follows according to the maturities of the underlying forward transactions.

The net changes in the fair value of these instruments improved the result of the financial year by EUR 19.8 million (charge of EUR 50.9 million).

Derivative financial instruments in connection with reinsurance

A small number of treaties in life and health reinsurance meet criteria which require application of the prescriptions in IFRS 4 “Insurance Contracts” governing embedded derivatives. These accounting regulations require that certain derivatives embedded in reinsurance contracts be separated from the underlying insurance contract (“host contract”), reported separately at fair value in accordance with IAS 39 “Financial Instruments: Recognition and Measurement” and recognised under investments. Fluctuations in the fair value of the derivative components are to be recognised in income in subsequent periods.

Within the scope of the accounting of “modified coinsurance” and “coinsurance funds withheld” (ModCo) reinsurance treaties, under which securities deposits are held by the ceding companies and payments rendered on the basis of the income from certain securities of the ceding company, the interest-rate risk elements are clearly and closely related to the underlying reinsurance arrangements. Embedded derivatives consequently result solely from the credit risk of the underlying securities portfolio.

Hannover Re calculates the fair value of the embedded derivatives in ModCo treaties using the market information available on the valuation date on the basis of a “credit spread” method. Under this method the derivative is valued at zero on the date when the contract commences and its value then fluctuates over time according to changes in the credit spreads of the securities. The derivative had a negative value of EUR 12.9 million as at the balance sheet date and was recognised under other liabilities (EUR 45.2 million under other financial assets at fair value through profit or loss).

Owing to the widening of credit spreads in the course of the year, the change in the fair value of the derivative gave rise to a negative profit contribution of EUR 55.4 million before tax (improvement of EUR 10.7 million in income).

The derivative components of another group of contracts in the area of life and health reinsurance were measured on the basis of stochastic considerations. The measurement produced a positive derivative value of EUR 8.2 million (EUR 9.3 million) on the balance sheet date. The derivative was recognised under other financial assets at fair value through profit or loss. The valuation resulted in a charge against income of EUR 1.1 million (EUR 0.6 million) as at 31 December 2011.

Pursuant to IAS 39 “Financial Instruments: Recognition and Measurement” the “Eurus II” transaction gives rise to a derivative, the fair value of which as at 31 December 2011 was –EUR 0.1 million (–EUR 6.8 million) and which we recognised under other liabilities as at the balance sheet date. Measurement resulted in an improvement of EUR 6.7 million in income in the year under review (charge against income of EUR 5.3 million). We would refer the reader to the explanatory remarks in Section 4. “Consolidation” regarding the securitisation of reinsurance risks.

All in all, application of the standards governing the carrying of derivatives in connection with the technical account led to recognition of assets totalling EUR 8.8 million (EUR 54.5 million) as well as recognition of liabilities from the derivatives resulting from technical items in an amount of EUR 13.0 million (EUR 8.5 million) as at the balance sheet date. Increases in income amounting to EUR 8.8 million (EUR 11.0 million) as well as charges to income of EUR 56.4 million (EUR 22.2 million) were recognised in the year under review from all separately measured derivatives in connection with the technical account.