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 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 without volatility adjustment or matching adjustment calculated in accordance with Solvency II rules. 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 decreased to EUR 13,041.8 million as at 31 December 2017, compared to EUR 13,461.0 million as at 31 December 2016 (pursuant to the Solvency II year-end reporting for 31 December 2016). The primary factor here was the general strengthening of the euro, especially against the US dollar. Shareholders’ equity held in foreign currencies consequently has a diminished value in euro. The reconciliation from measurement under IFRS to measurement under Solvency II is broadly stable, with underlying effects such as interest rate changes and other changes in the technical provisions largely cancelling each other out.

The required risk capital of the Hannover Re Group with the target confidence level of 99.5% decreased to EUR 4,729.0 million as at 31 December 2017, compared to EUR 5,149.5 million as at 31 December 2016. As with the shareholders’ equity, a key driver of the reduction here is the stronger euro against our major foreign currencies, especially the US dollar, and the associated lower foreign-currency volumes underlying the risks, including for example the volume of investments. In addition, lower market risks led to a decrease in the risk capital. With regard to regulatory capital requirements, the integration of the operational risk model – which was approved last year – also contributed to an increase in the Solvency II capital adequacy ratio.

As far as the market risks are concerned, last year’s reduction of the equity quota in the investment portfolio and lower spreads – along with volume effects driven by exchange rate movements – resulted in diminished volatility overall and hence less risk.

The underwriting risks in property and casualty reinsurance decreased primarily as a consequence of the weaker US dollar against the euro and slightly improved diversification within property and casualty reinsurance. The underwriting risks in life and health reinsurance increased owing to higher mortality risks due to more robust assumptions and model changes. The decrease in counterparty default risks is principally the result of a lower volume of receivables due from ceding companies and retrocessionaires as well as reduced volatility of the modelled losses.

The increase in operational risks can be attributed to a refined expert valuation.

The loss-absorbing effect of taxes and the diversification effect remained stable.

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 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.