Quantitative risk management methods

Hannover Re has developed an internal capital model for risk quantification as a central risk management tool. The purpose of risk quantification is inter alia to evaluate the capital resources of the Hannover Re Group and its individual companies. In addition, the model is used to establish the risk contribution made by individual business segments to the total company risk as well as the riskappropriate allocation of the cost of capital.

The internal capital model of Hannover Re is a stochastic enterprise model that establishes probability distributions for key performance indicators and balance sheet variables, such as company profit and shareholders' equity, in light of all major internal and external influencing factors, such as the insurance and investment portfolio, tax ratio and capital market developments. In so doing, the model draws on statistical, stochastic and actuarial methods and practices in order to ensure the most realistic possible representation of the company and its environment. The risk capital is calculated on the basis of a Value at Risk (VaR) with a confidence level of 99.97% (default probability of 0.03%) for an observation period of one year. As a vital subsidiary condition, this level of confidence also ensures that we exceed future regulatory capital requirements (e.g. the required confidence level of 99.5%).

The available capital rose sharply in the course of the year under review. Owing to the enlarged business volume, the required risk capital also increased. There was an increase in the diversification effect – a measure of risk spreading –, due particularly to the acquisition of the ING life reinsurance portfolio.

The available economic capital is composed of the three components of IFRS shareholders' equity (including minority interests), valuation reserves and hybrid capital. The valuation reserves for non-life reinsurance business primarily involve the difference between the nominal loss reserves according to IFRS and their discounted value, increased by the cost of capital needed to cover the fluctuation potential of the liabilities. In life and health reinsurance we show the difference between IFRS measurement and market- consistent measurement according to the Market Consistent Embedded Value principles. The measurement adjustments for investments derive from the difference between fair value and book value.

Of special significance to our company is the overarching diversification between our business segments and lines. As a result, we are able to enhance the efficiency of the allocated capital while at the same time reducing the required capital adequacy. 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.