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Quantitative risk management methods

In the interests of our shareholders and clients we strive to ensure that our risks remain commensurate with our capital resources. Our quantitative risk management provides a uniform framework for the evaluation and steering of all risks affecting the company as well as of our capital position. In this context, the internal capital model is our central tool.

The internal capital model of Hannover Re is a stochastic enterprise model. Based on predefined probability distributions, a large number of scenarios are generated for technical risks, counterparty defaults, capital market conditions and other business events and their effect on the company’s financial situation is determined. The central variable in risk and enterprise management is the economic capital, which is calculated according to market-consistent measurement principles and in many respects corresponds to the business valuation likely to be adopted in future under Solvency II.

The internal capital model encompasses all quantifiable risks and splits them into 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. The model enables us to consistently measure and aggregate the individual risks and to analyse the interactions between risks. Last but not least, we are able to verify whether the level of available economic capital exceeds the capital required to operate the business.

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 required risk capital of the Hannover Re Group increased in the year under review from EUR 5,484.7 million to EUR 5,967.9 million. The increase in market risks derives from a rise in investments and a rise in the proportion of corporate bonds and asset-backed securities combined with a reduction in the proportion of short-term investments and a decrease in securities with a “AAA” rating. The enlarged business volume in non-life reinsurance led to a rise in the risk capital for this business group. The increased credit risk derives, inter alia, from the rise in reinsurance recoverables due to the use of retrocession in the financial year. The decrease in risk capital in the life and health reinsurance business group is attributable above all to improvements in the mapping of future cash flows.

Available capital and required risk capital1
in EUR million 2012 2011
1 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 3,340.0 3,048.3
Underwriting risks in life and health reinsurance 1,973.5 2,029.1
Market risks 2,943.2 1,992.2
Credit risks 671.8 569.4
Operational risks 404.0 408.6
Diversification effect (3,364.6) (2,562.9)
Required risk capital of the Hannover Re Group 5,967.9 5,484.7
Available economic capital 10,379.7 8,758.7
Capitalisation ratio in % 173.9% 159.7%

The available economic capital increased in the period under review from EUR 8,758.7 million to EUR 10,379.7 million. This was due principally to the positive business result for 2012 and the issue of new hybrid bond. The change in the economic environment in 2012 – with higher credit spreads and further declines in interest rates – resulted in a rise in the valuation reserves for investments. The valuation adjustment for non-life reinsurance decreased above all owing to a higher risk premium, which reflects the increased capital requirements in this business group. The valuation reserves for life and health reinsurance climbed primarily on account of the positive development of new business.

Reconciliation 1 (economic capital/shareholders’ equity)
in EUR million 2012 2011
1 In contrast to the last annual report, the value adjustment due to operating costs is allocated to the individual business groups rather than the other value adjustments. The figures for the previous year have been adjusted accordingly.
Shareholders’ equity 6,740.3 5,606.7
Value adjustments for non-life reinsurance 560.2 883.1
Value adjustments for life and health reinsurance 819.7 751.6
Value adjustments for assets under own management 584.6 368.8
Tax effects and other (558.1) (583.1)
Economic equity 8,146.7 7,027.1
Hybrid capital 2,233.0 1,731.6
Available economic capital 10,379.7 8,758.7

The substantial increase in the available economic capital resulted overall in an increase in the coverage ratio to 173.9%. 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 specific valuation model. We establish the market-consistent value of technical items as the present value of projected future payments using actuarial methods. This is adjusted by a risk loading that factors in the fluctuation in future payments. Such fluctuations result from risks that cannot be hedged by means of capital market products, such as underwriting 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 market values and book values of our assets under own management, which under IFRS are recognised at book value. Other valuation adjustments relate inter alia 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. The internal capital model is based on current methods from actuarial science and financial mathematics. In the case of technical risks, we are able to draw on a rich internal data history to estimate the probability distributions, e. g. for the reserving risk. For risks from natural perils we use external models, which are adjusted in the context of a detailed internal review process such that they reflect our risk profile as closely as possible. In the area of life/health reinsurance long-term payment flows are modelled under various scenarios. With respect to all the aforementioned risks we use internal data to define scenarios and probability distributions. The internal data is enhanced by way of parameters set by our internal experts. These expert parameter settings are especially significant in relation to extreme events that have not previously been observed.

When it comes to aggregating the individual risks, we make allowance for dependencies between risk factors. Dependencies arise, for example, as a consequence of market shocks, such as the 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.

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.

Diversification effect within the non-life reinsurance business group

Diversification effect within the non-life reinsurance business group (bar chart) enlarge zoom

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