Risks emanating from non-life reinsurance are of crucial significance to our business operations. We make a fundamental distinction here between risks that result from business operations of past years (reserving risk) and those stemming from activities in the current or future years (price/premium risk). A significant technical risk is the reserving risk, i.e. the risk of under-reserving losses and the associated strain on the underwriting result. In order to counter this risk we calculate our loss reserves based on our own actuarial loss estimations; where necessary we also establish additional reserves supplementary to those posted by our cedants as well as an IBNR (incurred but not reported) reserve for losses that have already occurred but have not yet been reported to us.

Liability claims are a key influencing factor for the IBNR reserve. The IBNR reserve is calculated on a differentiated basis according to risk categories and regions. The IBNR reserve established by the Hannover Re Group amounted to EUR 4,249.6 million in the year under review. Asbestos- and pollution-related claims involve complex calculation methods. The adequacy of these reserves can be estimated using the so called “survival ratio”. This ratio expresses how many years the reserves would cover if the average level of paid claims over the past three years were to continue.

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The statistical run-off triangles used by our company are another monitoring tool. They show the changes in the reserve over time as a consequence of paid claims and in the recalculation of the reserves to be established as at each balance sheet date. Their adequacy is monitored using actuarial methods (cf. here Section 5.7 “Technical provisions”). Our own actuarial calculations regarding the adequacy of the reserves are also subject to annual quality assurance reviews conducted by external actuaries and auditors.

The table below lists the catastrophe losses and major claims that occurred in the 2010 financial year.

Licensed scientific simulation models, supplemented by the expertise of our own specialist departments, are used to assess our material catastrophe risks from natural hazards (especially earthquake, windstorm and flood). Furthermore, we establish the risk to our portfolio from various scenarios in the form of probability distributions. The monitoring of the natural hazards exposure of the Hannover Re portfolio (accumulation control) is rounded out by the calculation of realistic extreme loss scenarios. Within the scope of accumulation controlling, the Executive Board defines the risk appetite for natural perils once a year on the basis of the risk strategy. The risk appetite is a key basis for our underwriting approach in this segment.

For the purposes of risk limitation, maximum underwriting limits (capacities) are stipulated for various extreme loss scenarios and return periods in light of profitability criteria. Adherence to these limits is continuously verified by Group Risk Management. The Risk Committee, the Executive Board and the body responsible for steering non-life reinsurance are kept regularly updated on the degree of capacity utilisation. The limits and thresholds for the 100-year and 200-year aggregate loss as well as the utilisation thereof are set out in the table on the following page.

As part of our holistic approach to risk management across business groups, we take into account numerous relevant scenarios and extreme scenarios, determine their effect on portfolio and performance data, evaluate them in relation to the planned figures and identify alternative courses of action.

The price/premium risk lies primarily in the possibility of a random claims realisation that diverges from the claims expectancy on which the premium calculation was based. Regular and independent reviews of the models used for treaty quotation as well as central and local underwriting guidelines are vital management components. In addition, Hannover Re’s regional and treaty departments prepare regular reports on the progress of their respective renewals. The reporting in this regard makes reference inter alia to significant changes in conditions, risks (such as inadequate premiums) as well as to emerging market opportunities and the strategy pursued in order to accomplish targets.

The development of the combined ratio in non-life reinsurance is shown in the table below.

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All risks directly connected with the life of an insured person are referred to as biometric risks (especially the miscalculation of mortality, life expectancy, morbidity and occupational disability); they constitute material risks for our company in the area of life and health reinsurance. Counterparty, lapse and catastrophe risks are also material since we additionally prefinance our cedants’ new business acquisition costs. As in non-life reinsurance, the reserves are essentially calculated according to information provided by our clients and are also determined on the basis of secure biometric actuarial bases.

Through our quality assurance measures we ensure that the reserves established by ceding companies in accordance with local accounting principles satisfy all requirements with respect to the calculation methods used and assumptions made (e.g. use of mortality and morbidity tables, assumptions regarding the lapse rate. New business is written in all regions in compliance with underwriting guidelines applicable worldwide, which set out detailed rules governing the type, quality, level and origin of risks. These global guidelines are revised annually and approved by the Executive Board. Special underwriting guidelines give due consideration to the particular features of individual markets.

By monitoring compliance with these underwriting guidelines we minimise the potential credit risk stemming from an inability to pay or deterioration in the financial status of cedants. Regular reviews and holistic analyses (e.g. with an eye to lapse risks) are carried out with respect to new business activities and the assumption of international portfolios. The interest rate risk, which in the primary sector is important in life business owing to the guarantees that are given, is of only minimal relevance to our company owing to the structure of the contracts. The actuarial reports and documentation required by local regulators ensure that regular scrutiny also takes place on the level of the subsidiaries.

The Market Consistent Embedded Value (MCEV) is a ratio used for the valuation of life insurance and reinsurance business; it is calculated as the present value of the future shareholders’ earnings from the worldwide life and health reinsurance portfolio plus the allocated capital. The calculation makes allowance as far as possible for all risks underlying the covered business. The Market Consistent Embedded Value is established on the basis of the principles of the CFO Forum published in October 2009. Based on the latest available data published on 4 May 2010 (valid as of 31 December 2009), the table shows the MCEV 2009 and its sensitivity to selected scenarios in comparison with the corresponding sensitivities of the MCEV 2008.

The change in the MCEV under the scenarios shown captures the low volatility in this area and reflects our portfolio’s high degree of diversification. The consolidated MCEV before minority interests amounted to EUR 2,210.8 million (2008: EUR 1,652.0 million) as at 31 December 2009. This represents an increase of 33.8% (4.3%). The operating MCEV earnings totalled EUR 178.5 million (EUR 172.4 million), while the value of new business stood at EUR 83.9 million (EUR 150.5 million). The increase in the mortality sensitivities can be attributed to the business with a high mortality exposure written in 2009. This new business also reacts sensitively to changes in the lapse rate, hence additionally causing lapse sensitivities to rise. For more detailed information please see the Market Consistent Embedded Value Report 2009. We shall publish the MCEV for the 2010 financial year on our Internet website at the same time as the quarterly report for the first quarter of 2011.

We pursue an investment policy in which the primary emphasis is on the stability of the generated return. With this in mind, our portfolio is guided by the principles of broad diversification and a balanced risk/return ratio. Risks in the investment sector consist primarily of market, credit default and liquidity risks. The most significant market price risks are share price, interest rate and currency risks.

With a view to preserving the value of our assets under own management, we constantly monitor adherence to a trigger mechanism based on a clearly defined traffic light system that is applied across all portfolios. This system puts the accumulated fluctuations in fair value and realised gains/losses on investments since the beginning of the year in relation to a maximum loss amount, with an eye to clearly graduated trigger values. These are unambiguously defined in conformity with our risk appetite and trigger specified actions if a corresponding fair value development is overstepped. Owing to the favourable capital market environment in the year under review, the trigger utilisation in the 2010 financial year was consistently above the escalation levels – as shown by the graph on the following page.

Utilisation of the trigger system

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The short-term “Value at Risk” (VaR) is another vital tool used for monitoring and managing market price risks. The VaR is determined on the basis of historical data, e.g. the volatility of the securities positions under own management and the correlation between these risks. As part of these calculations the decline in the fair value of our portfolio is simulated with a given probability and within a certain period. The VaR of the Hannover Re Group determined in accordance with these principles specifies the decrease in the fair value of our securities portfolio under own management that with a probability of 95% will not be exceeded within ten trading days. A multi-factor model is used to calculate the VaR indicators for the Hannover Re Group. It is based on time series of selected representative market parameters (equity prices, yield curves, spread curves, exchange rates, commodity prices and macroeconomic variables). All correlations between these time series are reduced by analysis to a sensible number of main components. All asset positions are mapped on the level of individual positions through the APT model, i.e. the market price risks of all individual positions are reduced through mathematical operations to the market price risk factors of the model. Residual risks (e.g. market price risks that are not directly explained by the multi-factor model) can be determined through back-calculation and are accommodated in the overall calculation on the supposition of non-correlation.

The model takes into account the following market risk factors:

• interest rate risk,
• credit spread risk,
• systematic equity risk,
• specific equity risk,
• commodity risk,
• option-specific risk.

As part of ongoing refinements, we optimised our VaR calculation halfway through the reporting period, thereby enabling us to make more precise allowance for certain scenarios from market price risks associated with credit spreads. The values for the period prior to this recalibration were adjusted accordingly in the graph. In general terms, the market price risks continued to decrease in the year under review as a consequence of reduced volatility, and despite the move back into equities the Value at Risk in relation to the portfolio of investments under own management decreased year-on-year to around 0.7% as at the balance sheet date.

Value at Risk1 for the investment portfolio of the Hannover Re Group

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Stress tests are conducted in order to be able to map extreme scenarios as well as normal market scenarios for the purpose of calculating the Value at Risk. In this context, the loss potentials for fair values and shareholders’ equity (before tax) are simulated on the basis of already occurred or notional extreme events. Further significant risk management tools – along with various stress tests used to estimate the loss potential under extreme market conditions – include sensitivity and duration analyses and our asset/liability management (ALM). The internal capital model provides us with quantitative support for the investment strategy as well as a broad diversity of VaR calculations. In addition, tightly defined tactical duration ranges are in place, within which the portfolio can be positioned opportunistically according to market expectations. The parameters for these ranges are directly linked to our calculated risk-bearing capacity.

Further information on the risk concentrations of our investments can be obtained from the tables on the rating structure of fixed-income securities as well as on the currencies in which investments are held. Please see our comments in Section 5.1 “Investments under own management” of the notes.

Share price risks derive from the possibility of unfavourable changes in the value of equities, equity derivatives or equity index derivatives held in the portfolio. In the second half of the year under review we began to invest again in listed equities. The scenarios for changes in equity prices consequently have implications again for our portfolio. We spread the risks through systematic diversification. Please see also our comments in Section 5.1 of the notes, “Investments under own management”.

The portfolio of fixed-income securities is exposed to the interest rate risk. Declining market yields lead to increases and rising market yields to decreases in the fair value of the fixed-income securities portfolio. The credit spread risk should also be mentioned. The credit spread refers to the interest rate differential between a risk-entailing bond and risk-free bond of the same quality. Changes in these risk premiums, which are observable on the market, result – analogously to changes in pure market yields – in changes in the fair values of the corresponding securities.

Currency risks are especially relevant if there is a currency imbalance between the technical liabilities and the assets. Through extensive matching of currency distributions on the assets and liabilities side, we reduce this risk on the basis of the individual balance sheets within the Group. The short-term Value at Risk therefore does not include quantification of the currency risk. We regularly compare the liabilities per currency with the covering assets and optimise the currency coverage in light of relevant collateral conditions by regrouping assets. Remaining currency surpluses are systematically quantified and monitored within the scope of economic modelling. A detailed presentation of the currency spread of our investments is provided in Section 5.1, “Investments under own management”.

Real estate risks result from the possibility of unfavourable changes in the value of real estate held either directly or through fund units. They may be caused by a deterioration in the particular qualities of a property or by a general downslide in market values (such as the US real estate crash). Real estate risks continued to grow in importance for our portfolio owing to our continuous involvement in this sector. We spread these risks through broadly diversified investments in high-quality markets of Germany, Europe as a whole and the United States.

We use derivative financial instruments to a very limited extent. The primary purpose of such financial instruments is to hedge against potentially adverse situations on capital markets. In the year under review we took out inflation swaps to hedge part of the inflation risks associated with the loss reserves in our technical account. In addition, as in the previous year, a modest portion of our cash flows from the insurance business was hedged using forward exchange transactions.

The contracts are concluded solely with first-class counterparties and exposures are controlled in accordance with the restrictive parameters set out in the investment guidelines so as to avoid risks – especially credit risks – associated with the use of such transactions.

The credit risk consists primarily of the risk of complete or partial failure of the counterparty and the associated default on payment. Also significant here is the so-called migration risk, which results from a deterioration in the counterparty credit quality and is reflected in a change in fair value. Since the business that we accept is not always fully retained, but instead portions are retroceded as necessary, the credit risk is also material for our company in non-life reinsurance. Our retrocession partners are carefully selected and monitored in light of credit considerations in order to keep the risk as small as possible. This is also true of our broker relationships, under which risks may occur inter alia through the loss of the premium paid by the cedant to the broker or through double payments of claims. We minimise these risks, inter alia, by reviewing all broker relationships once a year with an eye to criteria such as the existence of professional indemnity insurance, payment performance and proper contract implementation. A Security Committee continuously monitors the credit status of retrocessionaires and approves measures where necessary to secure receivables that appear to be at risk of default. This process is supported by our “Cession Limits” Webbased risk management application, which specifies cession limits for the individual retrocessionaires participating in protection cover programmes and determines the capacities still available for short-, medium- and long-term business (cession management). Depending on the type and expected run-off duration of the reinsured business, the selection of reinsurers takes into account not only the minimum ratings of the rating agencies Standard & Poor’s and A. M. Best but also internal and external expert assessments (e.g. market information from brokers). Overall, retrocessions conserve our capital, stabilise and optimise our results and enable us to act on opportunities without restriction, e.g. following a catastrophe loss event. Regular visits to our retrocessionaires give us a reliable overview of the market and put us in a position to respond quickly to capacity changes. Through these close contacts with our retrocessionaires we are consistently able to provide a stable renewals forecast. The determination of our gross capacity is based on this forecast. Our assumptions are continuously updated during each renewal phase and also include a built-in safety margin. Not only that, additional capacities are kept available for potential defaults – although they are not normally required. The table on the following page shows how the proportion of assumed risks that we do not retrocede (i.e. that we run in our retention) has changed in recent years.

Alongside traditional retrocessions in non-life reinsurance we also transfer risks to the capital market. Yet credit risks are relevant to our investments and in life and health reinsurance, too, because we prefinance acquisition costs for our ceding companies. Our clients, retrocessionaires and broker relationships as well as our investments are therefore carefully evaluated and limited in light of credit considerations and are constantly monitored and controlled within the scope of our system of limits and thresholds.

The key ratios for management of our bad debt risk are as follows:

• 92.4% of our retrocessionaires have an investment grade rating (“AAA” to “BBB”),
• 91.8% are rated “A” or better.
• Since 2006 we have reduced the level of recoverables by altogether 66%.
• 31.7% of our recoverables from reinsurance business are secured by deposits or letters of credit. What is more, for the majority of our retrocessionaires we also function as reinsurer, meaning that in principle recoverables can potentially be set off against our own liabilities.
• In terms of the Hannover Re Group’s major companies, EUR 246.7 million (8.7%) of our accounts receivable from reinsurance business totalling EUR 2,841.3 million were older than 90 days as at the balance sheet date.
• The average default rate over the past three years was 0.1%.

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Retrocession gives rise to claims that we hold against our retrocessionaires. These reinsurance recoverables – i.e. the reinsurance recoverables on unpaid claims – amounted to EUR 1,025.3 million (EUR 1,748.0 million) as at the balance sheet date.

Reinsurance recoverables as at the balance sheet date

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The chart shows the development of our reinsurance recoverables – split by rating quality – due from our retrocessionaires. The decrease in the 2010 financial year was largely due to the balance sheet reclassification of the Clarendon Group as held for sale.

For further remarks on technical and other assets which were unadjusted but considered overdue as at the balance sheet date as well as on significant impairments in the year under review please see Section 5.4 “Technical assets“, Section 5.6 “Other assets” and Section 6.2 “Investment result”.

Credit risks from investments may arise out of the risk of a failure to pay (interest and/or capital repayment) or a change in the credit status (rating downgrade) of issuers of securities. We attach equally vital importance to exceptionally broad diversification as we do to credit assessment conducted on the basis of the quality criteria set out in the investment guidelines.

We measure credit risks in the first place using the standard market credit risk components, especially the probability of default and the amount of loss in the event of default – making allowance for any collateral and the ranking of the individual instruments depending on their effect in each case. We then assess the credit risk first on the level of individual securities (issues) and in subsequent steps on a combined basis on the issuer level.

In order to limit the risk of counterparty default we define various limits on the issuer and issue level as well as in the form of dedicated rating quotas. A comprehensive system of risk reporting ensures – as with all other investment risks – timely reporting to the persons involved within the scope of risk management.

The measurement and monitoring mechanisms that have been put in place result in a prudent, broadly diversified investment strategy. This is reflected inter alia in the fact that within our portfolio of assets under own management the exposures to government bonds or instruments backed by sovereign guarantees issued by the so-called PIIGS states amount to altogether just EUR 316.2 million on a fair value basis. This corresponds to a proportion of just 1.2%. The individual countries account for the following shares: Spain EUR 171.6 million, Ireland 63.8 million, Portugal 37.5 million, Italy 26.8 million and Greece EUR 16.6 million. No impairments had to be taken on these holdings. There is no risk of default here on account of bailout mechanisms existing on the European level (Eurozone safety net).

On a fair value basis EUR 3,097.5 million of the corporate bonds held by our company were issued by entities in the financial sector. Of this amount, EUR 2,648.0 million was attributable to banks. The vast majority of these bank bonds (almost 91.3%) are rated “A” or better. Our investment portfolio under own management does not contain any directly written credit derivatives.

In our understanding, this category encompasses the risk of losses occurring because of the inadequacy or failure of internal processes or as a result of events triggered by employee-related, system-induced or external factors. The operational risk also extends to legal risks. Operational risks exist, inter alia, in relation to the risk of business interruptions or failures of technical systems or they may derive from unlawful or unauthorised acts. Given the broad spectrum of operational risks, there is a wide range of different management and monitoring measures tailored to individual types of risk.

Core elements of risk management – for example with an eye to business interruptions and the failure of technical systems – are our contingency plans. These are designed to ensure the continuity of mission-critical enterprise processes and systems (recovery plans, back-up computer centre). The flexible working model of alternating telecommuting adopted by Hannover Re is, among other things, also a risk-minimising measure inasmuch as alternative workplaces and the requisite infrastructure are kept available on a decentralised basis. At the same time, we are thus able to offer the possibility of a healthy work/family balance. An important element of our human resources management policy, teleworking also reduces the risk of potentially losing key personnel by facilitating an attractive working environment.

As far as possibly unlawful or unauthorised acts are concerned, we enable our staff and partners to report serious breaches of the law pertaining to Hannover Re anonymously through our electronic whistleblower system. The information provided is brought to the attention of Hannover Re’s Compliance Office so that it can investigate potentially suspicious circumstances. All tips are handled in the strictest confidence.

The range of tools is rounded off with external and internal surveys of clients and staff, the line-independent monitoring of risk management by Internal Auditing and the internal control system.

Of material importance to our company in the category of other risks are primarily emerging risks, strategic risks, reputational risks and liquidity risks.

The hallmark of emerging risks (such as in the field of nanotechnology or in connection with climate change) is that the content of such risks cannot as yet be reliably assessed – especially with respect to our treaty portfolio. Such risks evolve gradually from weak signals to unmistakable tendencies. It is therefore vital to detect these risks at an early stage and then determine their relevance. For the purpose of early detection we have developed an efficient process that spans divisions and lines of business and ensured its linkage to risk management, thereby making it possible to pinpoint any necessary measures (e.g. ongoing observation and evaluation, the implementation of contractual exclusions or the development of new reinsurance products). This interdivisional and cross-line process is handled by an expert working group assembled specially for this task.

Strategic risks derive from the risk of an imbalance between the corporate strategy and the constantly changing general business environment. Such an imbalance might be caused, for example, by incorrect strategic policy decisions or a failure to consistently implement the defined strategies. We therefore regularly review our corporate strategy and risk strategy and adjust our processes as and when required.

A good corporate reputation is an indispensable prerequisite for our core business as a reinsurer. It often takes decades to build up a positive reputation, yet this reputation can be damaged or even destroyed within a very brief space of time. Management of this risk is made possible by our set communication channels, a professional approach to corporate communications, tried and tested processes for defined crisis scenarios as well as our established Code of Conduct.

The liquidity risk refers to the risk of being unable to convert investments and other assets into cash in order to meet our financial obligations when they become due. The liquidity risk consists of the refinancing risk, i.e. the necessary cash cannot be obtained or can only be raised at increased costs, and the market liquidity risk, meaning that financial market transactions can only be completed at a poorer price than expected due to a lack of market liquidity. Our regular liquidity planning and the liquid asset structure of our investments are core elements of our ability to manage this risk. These mechanisms ensure that Hannover Re is able to meet its payment obligations at all times. We manage the liquidity risk inter alia by allocating a liquidity code to every security. Adherence to the limits defined in our investment guidelines for each liquidity class is subject to daily control. The spread of investments across the various liquidity classes is recorded in the monthly investment reports and managed/monitored by way of appropriate limits. Roughly half of our investment holdings under own management can be liquidated on any trading day without a mark-down, a reflection of the high liquidity of our portfolio.