Internal risk assessment

In this section we compare the available economic capital with the required risk capital in greater detail. 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 payments using actuarial methods. This is adjusted by a risk loading that factors in the potential 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 discounting of future cash flows we use the risk-free basic yield curves calculated in accordance with Solvency II requirements and also for the first time effective 31 December 2018 the static volatility adjustment approved by the supervisory authority. Market prices for options and guarantees embedded in insurance contracts are determined or approximated using option valuation models from the field of financial mathematics. The volume of these options and guarantees in our portfolio is, however, comparatively slight. The adjustments for assets under own management shown in the following table indicate the difference between fair value and book value of those investments recognised under IFRS at book values. Other adjustments encompass above all the deferred taxes. The available economic capital, which is available as liable capital for policyholders, is composed of the economic equity and the hybrid capital and includes the deduction of foreseeable dividends as required by Solvency II. Hybrid capital is recognised at market-consistent value as required by Solvency II, with changes in the own credit risk not being included in the valuation.

The available economic capital increased to EUR 13,323.1 million as at 31 December 2018, compared to EUR 13,041.0 million as at 31 December 2017 (pursuant to the final Solvency II year-end reporting for 31 December 2017). The primary factors here were the positive business result and the adoption of the volatility adjustment. The development of shareholders’ equity was adversely impacted by, among other things, the increase in credit spreads and associated valuation declines in fixed-income securities, the large loss expenditure in property and casualty reinsurance and one-time charges in US mortality business.

The required risk capital of the Hannover Re Group with the target confidence level of 99.5% increased to EUR 5,135.4 million as at 31 December 2018, compared to EUR 4,729.0 million as at 31 December 2017. This was driven principally by the larger business volumes, which led to an increase in market risks and underwriting risks in property and casualty reinsurance. In addition, the weakening of the euro against the US dollar contributed to a rise in foreign-currency volumes and an increase in risks in euro.

Along with the larger volumes, elevated default and spread risks – as are also evident in the generally higher spread level – are a major reason for the increase in market risks. The underwriting risks in property and casualty reinsurance increased primarily as a consequence of higher underwriting capacities for natural perils and model adjustments made to specific large loss models. The underwriting risks in life and health reinsurance decreased due to a reduced exposure to longevity and mortality risks. This contrasts with a higher exposure to morbidity risks resulting from expansion of the business. The increase in counterparty default risks can be attributed principally to a higher volume of receivables due from ceding companies and retrocessionaires as well as elevated volatility of the modelled losses due to generally increased credit spreads.

The decrease in operational risks can be attributed above all to an updated expert assessment regarding the impact of individual scenarios.

The loss-absorbing effect of taxes remained stable. The slight decline in the diversification effect reflects the increase in certain key risks, namely the market risk and the underwriting risk in property and casualty reinsurance.

The internal capital model is based on current methods from actuarial science and financial mathematics. In the case of underwriting risks, we are able to draw on a rich internal data history to estimate the probability distributions, e. g. for the reserve 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 and health reinsurance long-term payment flows are modelled under various biometric and lapse 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 parameters 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 and based on their contribution to diversification.

The required risk capital with a confidence level of 99.5% reflects the loss from the respective risk that with a probability of 0.5% will not be exceeded. The risk capital required for specific risks is shown in each case before tax.