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8. Other notes

8.1 Derivative financial instruments and financial guarantees

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.

The change in equity from hedging instruments in an amount of -EUR 9.5 million that is recognised directly in equity pursuant to IAS 39 results exclusively from forward exchange contracts taken out within the year to hedge currency risks from long-term investments in foreign operations. Ineffective components of the hedge amounting to EUR 6.1 million were expensed under other expenses.

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 3.9 million (EUR 3.2 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 16.8 million (EUR 20.7 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 4.9 million (EUR 32.5 million) and other financial assets at fair value through profit or loss in an amount of EUR 13.1 million (EUR 12.2 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.

Maturity structure of derivative financial instruments
in EUR thousand 2012
  Less than
three months
Three
months to
one year
One to five
years
Five to ten
years
Total
Interest rate hedges          
Fair values (3,597) (330) (3,927)
Notional values 82,668 33,378 116,046
Currency hedges          
Fair values (935) (2,585) (10,696) (2,586) (16,802)
Notional values 12,237 77,969 36,395 11,038 137,639
Inflation hedges          
Fair values 9,094 (877) 8,217
Notional values 2,544,433 304,822 2,849,255
Total hedging instruments          
Fair values (935) (2,585) (5,199) (3,793) (12,512)
Notional values 12,237 77,969 2,663,496 349,238 3,102,940
Maturity structure of derivative financial instruments
in EUR thousand 2011
  Less than
three months
Three
months to
one year
One to five
years
Five to ten
years
Total
Interest rate hedges          
Fair values (3,158) (3,158)
Notional values 84,179 84,179
Currency hedges          
Fair values (870) (2,735) (12,015) (5,037) (20,657)
Notional values 11,348 7,830 39,339 21,574 80,091
Inflation hedges          
Fair values (14,638) (5,705) (20,343)
Notional values 2,868,253 308,564 3,176,817
Total hedging instruments          
Fair values (870) (2,735) (29,811) (10,742) (44,158)
Notional values 11,348 7,830 2,991,771 330,138 3,341,087

The net changes in the fair value of these instruments improved the result of the financial year by EUR 27.4 million (EUR 19.8 million).

Derivative financial instruments in connection with reinsurance

A 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 positive value of EUR 39.8 million as at the balance sheet date and was recognised under other financial assets at fair value through profit or loss (EUR 12.9 million under other liabilities).

In the course of the year the change in the fair value of the derivative gave rise to a positive profit contribution of EUR 51.8 million before tax (negative profit contribution of EUR 55.4 million).

A number of transactions concluded in the life and health reinsurance business group in 2012, under which Hannover Re companies offer their contracting parties coverage for risks from possible future payment obligations arising out of hedging instruments, are also to be classified as derivative financial instruments. The payment obligations result from contractually defined events and relate to the development of an underlying group of primary insurance contracts with statutory reserving requirements. The contracts are to be categorised and recognised as stand-alone credit derivatives pursuant to IAS 39. These derivative financial instruments were carried in equity on initial recognition because receivables recognised under other assets were to be carried in the same amount. Please see Section 6.6 “Other assets”. The fair value of these instruments on the balance sheet date was EUR 54.8 million, which was recognised under other liabilities. The change in value in subsequent periods is dependent upon the risk experience.

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 7.5 million (EUR 8.2 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 investment income of EUR 0.7 million (EUR 1.1 million) as at 31 December 2012.

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 47.7 million (EUR 8.8 million) as well as recognition of liabilities from the derivatives resulting from technical items in an amount of EUR 60.9 million (EUR 13.0 million) as at the balance sheet date. Increases in investment income amounting to EUR 52.0 million (EUR 8.8 million) as well as charges to income of EUR 7.1 million (EUR 56.4 million) were recognised in the year under review from all separately measured derivatives in connection with the technical account.

Financial guarantees

Structured transactions were entered into in the life and health reinsurance business group in order to finance statutory reserves (so-called Triple-X or AXXX reserves) of US ceding companies. In each case such structures necessitate the involvement of a special purpose entity. The special purpose entities carry extreme mortality risks securitised by the cedant above a contractually defined retention and transfer these risks by way of a fixed/floating swap with a ten-year term to a member company of the Hannover Re Group. The maximum capacity of the transactions is equivalent to EUR 1,137.9 million; an amount equivalent to EUR 848.1 million had been taken up as at the balance sheet date. The variable payments to the special purpose entities that are guaranteed by Hannover Re cover their payment obligations. By way of compensation agreements Hannover Re is reimbursed by the parent companies of the cedants for all payments resulting from the swap in the event of a claim. Under IAS 39 these transactions are to be recognised at fair value as financial guarantees. To this end Hannover Re uses the net method, according to which the present value of the agreed fixed swap premiums is netted with the present value of the guarantee commitment. The fair value on initial recognition therefore amounted to zero. The higher of the fair value and the amount carried as a provision on the liabilities side pursuant to IAS 37 is recognised at the point in time when utilisation is considered probable. This was not the case as at the balance sheet date. In this case the reimbursement claims from the compensation agreements are to be capitalised separately from and up to the amount of the provision.

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